“In factor-based investing, institutional investors look at the sources of risk and return behind securities’ prices—what are the true drivers of risk and return?” explains Don Robinson, CEO and chief investment officer (CIO) of Palladiem LLC, an investment management firm that serves the adviser community.
For example, for bonds, factors that may influence return include inflation expectation, short-term insulation based on federal policy, interest rates, interest rate spreads, performance over Treasury yield, credit risk and default risk. Robinson says there are fewer factor-based products for bonds, but he believes the industry will see more.
For equities, Robinson says, factors contributing to risk and returns have been explained by academic research. Factors include value; how a stock is priced today vs. in the next five to 10 years. He says if the stock is very expensive today, it will most likely revert to fair value over 10 years, and vice versa. Additionally, there is momentum, which covers irrational behavior such as investor reaction to news and chasing of performance—this consistently extends 10 to 16 months, then reverts back, he says. Quality is a measure of profitability for companies; more profitable companies generate higher returns. Low volatility is another factor; sometimes an equity has low volatility because it has been neglected. And the size factor is based on the theory that investing in risky smaller companies can pay off.
“Today, because of the rapid move of big data and technology, investors can slice and dice factors,” Robinson says. “There is way too much product and a lot of confusion.”
Matt Peron, managing director of global equity at Northern Trust in Chicago, says, years ago there were many institutional investors who needed help with active management and found that smart beta wasn’t working as they had expected. Northern Trust offered services to review data and found people generally had an expensive index fund because of over-diversification. “If they had 20 active managers, in theory they canceled each other out,” he says. “This led to lots of unintended risks and impure implementation of factor exposure.”
According to Robinson, rigorous application over 45 years has found that value, momentum, quality, low volatility and size will explain more than 95% of performance and risk. “Anything else is just noise; redundant application,” he says.
He notes a common frustration among portfolio managers is that most investors are uneducated about what factors are and how they are managed in a portfolio. “Our charge is to educate,” he says.NEXT: Applying Factor-Based Investing
Robinson says some products use a single factor, but the investor has to determine how much to weight that investment and how to manage changes that come over time. He recommends looking at a multi-factor exchange-traded fund (ETF) or strategy that embraces common factors. Plan sponsors should study the prospectus to determine the fund’s methodology.
Peron observes that plan sponsors don’t want to just take five factor managers and slam them together and hope for the best; they have to thoughtfully construct a program. “Start by working backward from objectives: risk tolerance, return, time horizon. Identifying these then allows for development of a factor program and the factor profile you need to be successful,” he says.
With factor investing, plan sponsors are trying to intelligently capture risk factors and be rewarded, Robinson says. He notes they can do that with technology, and should be able to cheaply, though not as cheaply as if buying in the regular market. However, he adds, the industry is seeing many providers reducing fees on smart beta design, which, according to Peron, is similar in design.
“Price is important. Methodology of execution is important. With technology and big data, factor investing can be done a lot cheaper,” Robinson says.
Peron acknowledges current low forecasts for equity returns, but says if plan sponsors consider value, they’ll find a good part of the market trading at seven times or 10 times earnings. “Value is quite cheap in this way,” he says.
According to Robinson, one of the attractive features of factor investing is that the main factors tend to be diversifiers together. For example, value tends to do well in bad conditions as opposed to momentum. However, he warns, investors should not try to time factors, but have some exposure to all factors. “Some are pro-cyclical—quality tends to do well when the market is slowing down, value does better when the market improves or comes out of recession,” he says.
Northern Trust evaluates what it calls the FER—factor efficiency ratio. Specifically, this computes a factor efficiency ratio that measures the percent of active risk coming from desired factor exposure. For example, if an index is value-oriented, how much active risk is coming from the value factor? When comparing multiple value indices, this metric provides an unambiguous interpretation of how efficient each index is at acquiring exposure to a given factor.
“In the coming five years, if returns become more muted, as some are expecting, the extra basis points [bps] that you might be able to achieve using careful factor investing strategies become that much more important,” Peron concludes.