Puzzling out the potential of factor investing
The concept of factor investing has come under some scrutiny, after some of the most popular forms of market weighting have failed to outperform a regular market capital weighting approach. But pro-factor investing market experts argue that now is a good time to consider raising factor allocations.
Paul Sandhu, head of multi-assets quant solutions and client advisory for Asia, based in Hong Kong said there are a few reasons why factor investing is ready to make a strong comeback. “Volatility is coming back and with it the opportunity to generate significant alpha,” he told AsianInvestor.
He added that alpha in the world’s stock markets has been “crushed by the beta factor, which ruled the market for last 10 years. Not until last year did beta start exhibiting higher volatility, which will advance further through 2020. This decompresses the alpha component, which can more effectively be targeted.”
For investors, Sandhu suggested a few key considerations when they formulate factor strategies. In particular, he said investors should be very cautious and diligent in selecting appropriate factors.
“For example, a simple carry factor (i.e. investing for yield across an asset class) can have a very different implementation across banks or asset managers, which involves different risks and can lead to widely different investment implications across market regimes.”
The portfolio construction work needs to be a little more sophisticated too.
“Many times, providers of factor strategies apply simplified or static approaches to allocation across the factors. These approaches may work in positive-returning markets, but fall apart during market turbulence,” said Sandhu.
“It is important for a manager to not only dynamically adjust allocations to risk premia in line with their investment views, but sometimes more important is the ability to explain why the allocation has out/under performed.”
EDUCATION REQUIRED
Investors would also be well-advised to better educate themselves on the benefits and drawbacks of factor investing.
“In Asia there are large sophisticated institutions who are still in the learning phase of factor investing,” said Stephen Quance, the Singapore-based global director for factor investing at Invesco. “We don’t consider the factor premium to be alpha in the same way as people typically think of it. True alpha you expect to capture from your skill as a fund manager, which shouldn’t be market dependent. But factors are more systematic and structural than that.”
He added that this different approach also applies to the concept of beta.
“People seem to be very comfortable with the idea that equity markets can turn negative for a period of time.” Investors need to understand what they are getting into and what their realistic expectation should be, he argued. And differentiating between factor investing and alpha is a key consideration.
“If it’s alpha you are getting excess return per unit of risk, more of an idiosyncratic thing, as opposed to a reward for some sort of risk or structural anomaly,” said Quance.
“Once everybody knows about alpha it might go away, if everyone rushed towards it. But if there’s a risk-return trade-off you wouldn’t expect to go away with a factor, even if everyone in the world knows about it. Some investors will bear that risk and others won’t.”
Sandhu added that the aggregate risk exposure becomes even more important for factor investing strategies than traditional active investing or market capitalisation-based passive indexes.
“The focused return aspect of these factor strategies [means] risk exposure becomes multiplied. Understanding the underlying risk exposure and how the risk exposure for these strategies correlates with the rest of the portfolio is extremely important.”
Liu Li-ju, deputy direct general of Taiwan's Bureau of Labor Funds (BLF), a large user of factor indexes, noted that its top consideration is liquidity; it has typically focused its factor strategies in large asset classes (e.g. equities) while leaving some risk budget to operate in others (e.g. US Treasury bonds) and regionals (such as Asia and emerging markets).
“We are still cautious to develop smart beta strategies and separate the alpha and beta exposure for all assets within our core portfolio,” said Liu.
GROWING PAINS
While demand for information about factor investing continues to grow, asset owners clearly still need to go through a learning process to correctly apply factor strategies into their portfolios.
The next phase is for investors to apply factor strategies within their fixed income segment. However, there is currently a shortage of appropriate products. BLF recently postponed plans to employ enhanced indexing strategies in its fixed-income investments, precisely because it is struggling to find appropriate factor-based benchmarks.
For all the complexities, factor investing looks set to keep gaining traction, in fixed income and equities alike. It can be a complex asset class, and investors need patience. But over the long term, it can still reward.
This article was adapted from a feature story on factor investing that first appeared in AsianInvestor's Winter 2019 edition.