Factor attraction: why multi-factor investing is on the rise
Over the past 20-odd years, many investors have started expanding their portfolios into alternative asset classes, such as hedge funds and commodities, in order to improve diversification. However, the past decade has seen a significant part of the purported correlation benefits turn out to be misleading, or at least absent when most needed.
Exacerbating this is the fact expected returns on the two main return drivers of most portfolios – equity and bond markets – are also now at seemingly historical lows.
Factor-based strategies are there to help. Factor strategies are proven, systematic strategies, based on a clear economic rationale, that show persistent superior risk-adjusted returns across markets and over long periods of time. They provide attractive expected returns, especially when they harvest multiple factors across asset classes, supported by over multiple decades of (academic and investment) research and investment applications. Recent research by Robeco confirms the existence of factor premiums in global (including Australian) markets all the way back to the 19th century.
Further, factor-based strategies come mostly with low correlations to traditional asset classes. As such, they are set to provide a natural solution to these challenges.
How do factor strategies work? They boil down to transparent investment rules in which you score every asset in your universe on measures of the factors and you build a portfolio with good exposure to these measures, while managing all your risk.
For example, an equity value factor strategy systematically ranks all the stocks in the universe in order of attractiveness based on measures like a stock’s valuation and buys those that are top ranked. Due to the systematic nature, this process is very scalable and transparent, so that a very large investment universe can be efficiently evaluated.
Instead of buying the whole market with index weights (as holds for passive strategies), or a small subset of the investment universe (as commonly holds for fundamental active portfolios), factor portfolios can screen the whole universe and over or underweight hundreds to thousands of instruments simultaneously. At the same time, it eliminates the human or emotional biases that might at times drive investment decisions. Then a multi-factor investment model uses a number of factors simultaneously in its assessment of market prices, targeting exposure to the underlying factors to achieve the maximum possible return-risk tradeoff.
Commonly characterised as market-neutral, highly liquid and demonstrating remarkable levels of transparency in their investment processes, factor-based strategies can be used as portfolio enhancers next to traditional investment approaches, as well as hedge fund allocations. Furthermore, the rules-based nature of factor investing makes them a lower-cost alternative to typical active funds, in particular, hedge funds.
HOW IT WORKS IN PRACTICE
Every factor-based asset manager will employ a slightly different approach, and there are many factors to choose from in the investing universe. Robeco has identified six key multi-asset factor premiums: low risk, value, momentum, quality, carry, and flow.
The low-risk factor is the fact that securities characterised as low risk achieve higher risk-adjusted returns than high-risk assets, within an asset class. For individual stocks, for example, low risk involves ranking stocks based on volatility, beta and distress risk and buying the low-risk assets relative to the index.
The value factor is that undervalued assets outperform expensive ones. Market prices are subject to overvaluation and undervaluation cycles, which eventually reverse over the long run. That is, buy low, sell high.
The momentum factor represents the fact that, on average, recent winners outperform, and recent losers underperform. In other words, follow the trend.
The quality factor is the empirical finding that high-quality assets outperform assets with low underlying quality. Quality is linked to the favourable nature of macroeconomic fundamentals for that market. In the case of government bonds, for example, if we expect inflation to decline in a specific market, interest rates will likely decline as well, which means the macro environment is favourable for that bond market.
Carry captures the yield of an asset. For example, the carry of a US/Australian dollar currency forward is the difference between the respective US and Australian interest rate. And an investor will earn this difference exactly if the exchange rate does not change.
Flow captures the impact of predictable buying and selling pressures, or liquidity characteristics. In other words, exploiting supply and demand. These price pressures create price distortions and needs for liquidity provision, which result in a flow factor premium across markets.
Each of these six key factors delivers superior returns, in individual asset classes, but also when combined across asset classes. In fact, it turns out factor premiums can be harvested in all major markets and asset classes, well beyond developed market equities. A multi-factor, multi-asset approach applies this knowledge and executes factor investing across several asset classes. As correlations between value, momentum, low risk, quality, carry and flow, when applied to all assets, are also close to zero, such a portfolio benefits from strong diversification benefits. These lead to more stable returns over time compared to an investment restricted to a subset of the different factors. Importantly, they have the ability to significantly enhance the net returns and diversification benefits of a traditional portfolio at limited cost and with sufficient liquidity.
This multi-factor multi-asset approach targets equity-like returns at a balanced risk profile, while at the same time aiming for close to zero correlations with equity markets. In this approach, there’s a stable risk balance between the factors and a wide investment universe to harvest factor premiums. These include a wide set of individual equities (developed and emerging markets, large caps and small caps), individual bonds (investment grade and high yield corporate bonds) and strategies implemented at the market-level in equity, bond, currency, credit and commodity derivatives.
Sustainability is also something that needn’t be ignored in factor investing. Integrating sustainability in the investment process can be achieved through various methods, including ensuring the environmental, social and governance (ESG) score is above that of the referenced indices, as well as applying exclusion lists to avoid companies involved in weapons, tobacco and the like.
By combining multiple factor premiums across all major asset classes, many diversifying returns sources are combined to achieve stable expected returns. These factor premiums can be harvested in wide investment universes and can be harvested in a liquid and sustainable manner.
BENEFITTING OTHER INVESTMENT STRATEGIES
The factor approach provides strong diversification benefits when added to a traditional multi-asset portfolio and can be used to complement existing portfolio allocations. Implementing factor investing within specific asset classes, in particular, equities, is now a widely accepted approach, as it improves the likelihood of increasing returns while reducing risk.
A multi-factor multi asset approach fits well as a true portfolio diversifier next to traditional investment approaches. Many investors see our solution as portfolio diversifier, a diversifier in their equity or multi-asset allocation, or a (sustainable) liquid alternatives product. Furthermore, many investors see such a solution as an alternative to typical active funds, in particular, hedge funds.
Combined with its systematic nature and attractive diversification properties, this strategy represents a lower-cost, evidence-based, more transparent and more liquid solution compared to other strategies with the conventional hedge fund space.
In effectively implementing a factor-based investment strategy, investors should seek out managers with experience managing quantitative strategies, and who extend the reach beyond the more standard practice of factor-based selection in developed markets equities.
The appeal of factor investing can only grow, with greater diversification, higher returns and lower risk wrapped up in single investment strategy. It’s a win for investors and creates efficiency for asset managers offering this progressive, dynamic approach.
Guido Baltussen is lead portfolio manager (liquid alternatives and multi-asset strategies) at Robeco.
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