Focus Needed for Factor Investing

“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?” says 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 introduced.

Equities have a different set of factors, which contribute to risk and returns and have been explained by academic research, Robinson says. These include value—e.g., how a stock is priced today vs. in the next five to 10 years. He says if the stock is very expensive now, 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—those more profitable, unsurprisingly, 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, says, years ago there were many institutional investors who needed help with active management and found that smart beta failed to work 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 risk 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. The industry needs to educate investors about how factor investing works, he recommends.