Bringing the X factor

31 July 2020

Over the past decade, prominent institutional investors have publicly embraced factor-based approaches to securities selection and portfolio allocation. 
 
Concepts such as value investing or low-volatility investing have gained popularity, with the number of retail investors introducing factor-based products into their portfolios also increasing substantially in recent times.
 
Factor investing is an approach used by asset managers that involves targeting specific drivers of return across asset classes, and can help improve portfolio returns, reduce volatility and enhance diversification. Factor-based strategies can help to significantly improve the return-risk profile of a portfolio, for example, by reducing downside risk or enhancing long-term returns.
 
Yet not all factor products are created equal. For instance, generic factor-based strategies can be prone to some common pitfalls. Applying an enhanced multi-factor approach can help mitigate many of these issues. Focusing on efficiently combining factor premiums and making sure premiums do not clash or compete with each other will ensure a positive exposure to all the desired factor premiums over time.
 
The rise of factor investing in recent years has largely resulted from large flows into exchange traded funds (ETFs) based on popular smart beta indices. While these relatively generic products offer exposure to factors in a transparent way and at relatively low management fees, they can incur significant hidden costs.
 
Smart beta indices are also prone to overcrowding and arbitrage, and while strategies based on generic factor indices may be fully transparent, this transparency comes at a cost to investors. It means that other investors can identify in advance which trades are going to be executed, and can opportunistically take advantage of this.

IDENTIFYING THE REQUIRED FACTORS 

Since the first factors were reported in the 1970s, hundreds of individual factors have been identified in the academic literature and implemented into investment portfolios, with varying degrees of success. Different asset managers will adopt different factors for a number of reasons, including the individual market and economic nuances at play.
 
Most factors tend to be related to one another and ultimately measure the same phenomenon, whereas others only seem to work over short periods of time, or in a limited number of segments of the market. Research shows it is possible to bring the number of factors down to just a handful that consistently perform over multiple time periods and across markets.
 
Investors should therefore be selective and focus on a small number of factors that are performing with superior risk-adjusted returns, proven, and have an economic rationale with strong academic underpinnings. 
 
There are typically four main factors that meet these required criteria across equities, including:
  1. Value: The value effect is the tendency of inexpensive stocks, measured for example by the price to-book ratio, to achieve above-market returns. This phenomenon has been extensively documented in the academic literature, where it has been identified over long periods of time and in a variety of regions, including the US, Japan, Europe and emerging markets. A concern with conventional value strategies is that these are typically exposed to elevated levels of distress risk and other value traps. However, empirical evidence shows distress risk is not driving the value premium and such value traps are therefore better to be avoided.
  2. Momentum: Momentum is the tendency for stocks that have performed well in the recent past to continue to perform well; and for stocks that have performed poorly to continue to perform poorly. The momentum effect was first documented in the early 1990s, and has been confirmed in numerous subsequent studies. The momentum premium is one of the largest factor premiums, but its sensitivity to market reversals and high turnover are two well-known issues that can deter the implementation of this type of strategy among some asset managers.
  3. Low volatility: Low-risk stocks generate higher risk-adjusted returns than high-risk stocks, as demonstrated as far back as the 1970s by Robert Haugen and James Heins who showed that low-beta stocks earn higher risk-adjusted returns than high beta stocks in the US market. However, generic low volatility strategies are typically based on a single backward-looking historical risk measure, such as volatility or beta, and this construction may expose the strategy to some pitfalls, such as miscalculated downside risk. A more sophisticated approach can overcome these issues, by taking a multi-dimensional view of risk. This means using several low-risk variables, that include both long- and short-term statistical data. 
  4. Quality: The quality effect is the tendency of high-quality stocks to outperform low-quality stocks and the market as a whole. Stocks of companies with high profitability, high earnings quality and conservative management are seen as high-quality stocks. The quality effect was first documented in the early 1990s where (low) accruals were used as an indicator for sound earnings quality. A key concern with generic quality strategies is that they use poor definitions. For example, quality is often measured by financial leverage or earnings stability, which are actually more related to the low volatility factor. Other quality definitions, such as growth in profitability or earnings growth, can have weak or no predictive power for future returns.
One of the most hotly-debated topics in the field of quantitative finance is whether investors should try to tactically time their exposures to factors. Single-factor portfolios can experience periods of relative underperformance or outperformance that can last multiple years. As a result, timing may appear like an appealing option, in principle. 
 
However, there is little evidence that it is possible to predict accurately which factors are going to do well in the near future, especially if one takes the high transaction costs into account that are involved with timing factors. Instead of tactically trying to identify the best one, it is usually far more rewarding to strategically diversify across factors to be successful.
 
By combining various individual factor strategies, it is possible to produce a multi-factor portfolio that offers high exposure to multiple factor premiums, minimises turnover and avoids the individual factors competing against each other. This methodology results in efficient and balanced exposure to all proven factors. This leads to a better expected risk-adjusted return in the long-run for the multi-factor equity portfolio. 
 
ADDING SUSTAINABILITY INTO THE FACTOR MIX
 
As with many other investment philosophies, sustainability is increasingly front of mind for managers needing to cater to the demands of environmentally-conscious investors in both Australia and globally. Excluding stocks with poor environmental, social and governance (ESG) ratings is now regarded as a viable investment option, with performance now stacking up accordingly.
 
Factor strategies and sustainable investing can make a good combination. The rules-based nature of quant models makes it relatively easy to integrate additional quantifiable variables into the security selection and portfolio construction process. From this perspective, integrating sustainability criteria into investment methodology can be similar to a standard factor-based approach, where securities are selected based on their factor characteristics. 
 
Through a factor approach, asset managers can create an investment portfolio that strikes a balance between sustainability objectives and risk and return expectations for each client. Empirical research increasingly points towards the ability to achieve improved sustainability profiles with proven return factors.
 
One approach is for the manager to ensure that the weighted ESG score of every portfolio is at least as high as that of the reference index. If the portfolio generated by the stock selection model scores below average on sustainability, the portfolio construction tool will select stocks that improve the portfolio’s sustainability profile. 
 
Securities from companies with a higher ESG score are therefore more likely to be included in the portfolio. Subsequently, this approach positively screen stocks, in contrast to an exclusion policy that only allows negative screening. This enhanced form of ESG integration ensures the risk of being overexposed to less sustainable companies is avoided, while maintaining exposure to top-ranked stocks.
 
Using more generic approaches to sustainability can present issues, including the simplicity of the approach to ESG scoring leading to undesired biases, and the level of sustainability integration these products offer often being too basic, making it impossible to adjust them to specific client needs.
 
Factor investing is a unique to forming an investment portfolio, and gives more control to asset owners on how their portfolio behaves and what it looks like. The application of factors enhances diversification, generates strong returns and, importantly, assists in managing the risk profile of a portfolio.  
 
Simon Lansdorp is portfolio manager – factor investing equities at Robeco.



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