Be clear on factor strategies’ benefits

Factor investing has been hard to ignore in the last few years. Many new products (often termed smart beta) seemingly offering a silver bullet for investors, claiming sustainable excess returns with high levels of transparency and low fees; however, the practical benefits of factor-focused smart-beta strategies, within the context of long-only equity investing, are not as clear as they might first seem. Such strategies require careful consideration before investing.

Until recently, investors wishing to gain exposure to equity markets had a simple choice of tracking a market-cap index or investing in traditional (and significantly more expensive) active approaches. The development of factor solutions provides a middle ground, and while they are far from homogenous, broadly speaking, factor strategies do bring tangible benefits. Chiefly, these include:

• Low cost, with management fees often not much more than for tracking a market cap-weighted index
• Transparent process targeting well-known return premia
• A focus on absolute risk, not relative risk, thereby avoiding the index-like behaviour of some traditional active approaches.

Beyond these broad characteristics, however, the conversation becomes less clear. Firstly, factor strategies are not clearly defined and cover a wide range of capabilities and approaches. As such, they require careful consideration and we caution against treating them as passive or low-risk approaches to equity investment. Factor strategies and factor indices can involve material deviations from the market-cap index and can often be complex. They require active decisions around portfolio construction and, like traditional active approaches, provide no guarantee of success. Investors should apply the same level of diligence to the assessment of factor or smart-beta solutions as they would to any active approach.

It is also important to distinguish between the different types of factor-based strategies available; for example, simple factor indices can be dangerous, due to their relatively naïve approach and static design. In the case of published indices, rebalancing may be gamed by other investors, making them more prone to risks such as crowding – especially if similar strategies are also offered in exchange-traded funds. Comparable factor-focused outcomes may be generated by a more dynamic approach with investment manager oversight at only marginally higher costs.

Having said that, the development of a range of low-cost, factor-based investment options does present new opportunities to consider. The specific implications will vary depending on each investor’s circumstances and beliefs, but potential actions include:

Investors with a (traditional) actively managed equity portfolio should ensure that it is well-diversified by style factor. To the extent that such portfolios are over- or underexposed to certain factors, actively managed (as opposed to index) factor strategies may play a useful role in plugging any gaps (that is, as a completion portfolio).

Investors who are able to develop a higher degree of conviction in the investment case for factor exposures than they can for traditional active management may wish to hold a core of their equity exposure in active (non-index) multi-factor strategies. This reflects the fact that an investor’s conviction level will play an important role in determining the likelihood that an investor holds onto a manager during periods of underperformance versus market cap.

Investors who already make use of traditional quant strategies may wish to review such holdings against comparable (but typically lower cost) actively managed multi-factor strategies. In some cases, investors may find that a well-constructed active multi-factor strategy offers factor biases and portfolio oversight very similar to a traditional quant strategy, but for lower fees.

Investors making use of factor indices may wish to compare such approaches against active multi-factor strategies. For a relatively small increase in fees, active multi-factor approaches offer superior risk management and portfolio evolution over time.

In short, factor strategies vary greatly and should be considered a form of active management, even when offered in index format. Some factor strategies can play a useful role in building robust equity structures, bringing cost and transparency benefits; however, as with all active approaches, investors need to ensure that they have a full understanding of each strategy’s characteristics, pitfalls and expectations before investing.

Rich Dell, is head of equity manager research at Mercer Investments.