Interest in factor strategies has been growing ever since the global financial crisis, when investors saw that many traditional asset classes behaved in the same way in stressed market conditions.
Since then, fund managers have launched a host of passive strategies which claim to deliver returns that are not based on traditional market cap indices like the FTSE 100, but through following rejigged indices, which prioritise certain factors.
For example, a Low Volatility fund will follow a benchmark index which gives greater weight to assets with lower volatility characteristics, while a Momentum fund will only invest in securities that are “popular” in the market with better returns than their peers in recent months.
In 2013, MSCI recognised just six factors as genuine sources of risk premia: Momentum, Value, Small Cap, Low Vol, High Dividend and Quality. But the past five years has seen an explosion in new ‘risk premia’ factors.
With hundreds more factors now available to investors, fund manufacturers have been keen to capitalise on investor concerns such as the vulnerability of equity markets, or the underperformance of diversified growth funds.
State Street Global Advisors head of equity portfolio strategists, EMEA Ana Harris says the organisation has committed extensive resources to “harvesting” individual factors so they can explain to clients why they exist and the rationale for using them. One element of the asset manager’s work has been focused on analysing individual factors to see how, or if, they can enhance passive returns, while assisting investors with risk management.
“In the defined contribution space, we have been looking at target date funds and looking at factors on that glidepath,” she explains. “We have been looking at the potential additional return you might have and how that is correlated with other parts of the glidepath and your other allocations.”
Harris says that factor- orientated strategies may appeal particularly to the DC market as they seek to diversify their asset allocation as broadly as possible within strict cost parameters.
Recognising the appeal
A research paper on the developing factor market, published last year by investment consultants Aon, suggests investors believe factors to be compelling in the current market due to three reasons.
Firstly, it suits investors seeking to ‘reduce sensitivity to equity market movements through low-volatility investments’ and it appealed to those who are ‘seeking different sources of returns but may have governance or cost constraints or have an aversion to significant active risk’.
The final reason found by Aon’s team was that some investors believe that these strategies offer the potential to improve ‘long- term risk-adjusted returns of an equity portfolio by investing in a combination of factors’.
So, will factors make portfolios cheaper, invincible, and give excess returns? Well, no. But, there is evidence to suggest that it might improve your chances.
SSGA’s Ana Harris says there is now “a long-term data set for things like value, small cap or momentum” which clearly shows premium and how it behaves over time. But she cautions:
“Just because it existed in the past…. we need to be comfortable that it will carry on existing in the future. Momentum is very much linked to the behaviour of individuals, institutions and financial players in the market. So, their reactions can impact share prices. “It is important to have the data, but also for us to go through it with clients and explain why it existed in the past and why it may or may not in the future as well.”
EDHEC, a graduate business school in France, has become something of an authority on the subject of factor-based investing. Its globally renowned Risk Institute regularly releases academic studies that analyse asset managers’ claims. In its most recent paper, published in February, it noted that investors can further improve the ‘risk return characteristics of individual factors’ by constructing multi-factor portfolios.
Despite the encouragement from both academics and fund firms, some in the advisory community say the defined contribution market has been slower to embrace factor-based investing than those in the wider institutional investment market, however.
JLT Employee Benefits head of strategy for investment consulting Jignesh Sheth says demand for factor-based strategies in the DC market has been relatively low to date but says that trustees will always be cautious in embracing something that their members may not initially understand.
He says: “If you look historically, different factors do well at different times, so it is more about having a philosophy of saying I don’t want to invest according to market weights. That is maybe a nuance that the average DC investor is not thinking about.
“They understand about active management, Value and Growth, but in terms of some of the drivers as to where factor investing has come from, there is always a danger, if you are a trustee, that your members won’t understand what it is that you have put them in.” Sheth warns that in times of market deviation, members may find it difficult to understand why an equity strategy with a factor tilt may perform differently to a straightforward equity fund.
Despite this, the Pensions and Lifetime Savings Association (PLSA) has been keen to emphasis the benefits that embracing a factor approach can have to schemes.
In 2017, the trade group jointly released a paper with fund group Robeco to extol the benefits of factors, citing an academic study of how the Norwegian Government Pension Fund was managed after the financial crisis.
It said: “The added value of the fund’s active management did not reflect true skill, but could in fact be explained by implicit exposure to a number of systematic factors.” The academic study referenced in the PLSA paper recommended the adoption of a factor investing approach.
What happens if everyone does factors?
Some have raised concerns that factor-based investing is vulnerable to the approach being adopted by a majority of investors in the market. Earlier this year, a report in the Economist documented a London Business School event where academics warned that “as more investors took a factor-based approach, excess returns would indeed decline”.
While traditional single-factor strategies may be gaining sufficient appeal to warrant the warning of a crowded trade, there is one area where DC investors have been keen to encourage growth – the world of environmental, social and governance-based investing.
State Street Global Advisors head of equity portfolio strategists, EMEA Ana Harris says that demand for funds following rebalanced indices using a range of ESG factors has been particularly high among DC investors as they are increasingly seeing sustainable investing as important to managing the risk in their portfolio.
She explains: “DC members tend to be slightly younger and research shows these age groups are more aware of ESG issues and want to see more of that represented in their pension.
“On the other side, what we are seeing is this can benefit returns and minimise the exposure of risks that we may not be quantifying well today – like climate change.”
Harris says that ESG smart beta approaches can be difficult to quantify from a pure financial incentive, but provide another dimension of analysis nonetheless.
While these newly identified smart beta funds obviously don’t have the benefit of the years of live testing, DC schemes seem to be benefiting from an ever-increasing range of new options. In the years to come, the factors upon which these funds are based, may yet become widespread, if not the norm.
