Fund managers ‘struggling to explain’ complex factors

Experts told the audience of the Inside ETFs Asia conference that understanding and transparency are essential to successfully invest into smart beta ETFs in the region.
Fund managers ‘struggling to explain’ complex factors

The technology and mathematics behind factor investment strategies has grown increasingly complex, even as the number of factors has soared.

The combination has left many fund managers struggling to explain such factor investing approaches to their clients even if they may align with their investment priorities, experts told the audience of the Inside ETFs Asia event, produced in association with AsianInvestor, on November 8 in Hong Kong.

“The problem that we find with the more traditional financial practitioners is that when they look at these technologies, it becomes very difficult to describe these factors,” Sutee Mokkhavesa, senior executive vice president of risk, strategy & investment-linked business for Muang Thai Life Assurance, told onlookers.

“I can explain very mathematically how to come up with the allocation,” he added, “but the fact of it is it’s still pretty heavy math to comprehend something like this.”

Factors consist of an alternative means of measuring investable assets aside from market capitalisation. Traditional factors like momentum, growth, and value are well established means of creating investment portfolios, but Sutee believes these factors alone may not be enough for modern investment needs.

“My sense is, you can actually go further than that,” he told AsianInvestor. “You can go and look at these factors that have no names, actually.”

Such nameless factors are derived through advanced mathematics, such as principal component analysis, which decomposes select factors out of a market portfolio, Sutee explained. The trouble is that the resulting portfolio, a mathematical construct, is difficult to render in investment terms.

“It’s not a market portfolio, it’s not a momentum portfolio, it might not be a growth portfolio,” he said. “That makes it difficult for people to grasp.”

That is a challenge, given that understanding the investment attributes behind factor investing and smart beta is particularly essential to new users of such products, said Jean-Louis Nakamura, chief investment officer for Asia Pacific and head of the Hong Kong office at Lombard Odier Group.

“The first priority should be the transparency of the exposure to the underlying factor,” Nakamura said. This includes the methodology behind the construction of the smart beta fund, and being able to find the right instrument that exposes the portfolio to the right factor, or the right set of factors, he added.

Spoiled with choice

Transparency is crucial when considering which factors to consider, Sutee agreed, but he noted that the problem is largely one of choice, with there now being over 240 known factors that generate alpha.

“Imagine that number of factors out there,” he told the audience, “the problem that investors will have is how to pick the right one.”

One way to decipher which factors to use is to stick with academically-backed factors and focus on ones that have few performance ties, said Nakamura. “We prefer, by far, limiting the number of factors by choosing or trying to select factors which are clearly different and uncorrelated,” he said.

Even after picking the right factors, there’s a limit to how effective uncorrelated factors are in generating alpha. Investors can get caught up in stacking lots of low level correlation factors together, said Sutee, thinking that this will increase returns.

“As you add more factors, your alpha will go up,” he said, “and it will not go up indefinitely. It will plateau and it will come down.” In the end, only a handful of factors may be necessary, he added, as to add more would risk diversifying away the alpha of the investment. 

Sutee said he sees huge potential in exchange-traded funds and factor investing in Asia, given the size of the regional market versus the US.

“There’s plenty of investment opportunities out there,” he said. “I think we need a bit of time and market development, and people to become more familiar with it,” he added.

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