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Why is factor investing a ‘thing’?

There’s a lot of hype around a trend called ‘factor investing’ which (as part of broader ‘smart beta’ thinking) has been called “the fastest growing segment of the investment management industry” (for example, this article). But what is factor investing, why is it important and why do many believe it is more than just a fad? This is written from the perspective of a large superannuation fund equity investor.

Starting with the basics

Let’s begin with the simple notions of ‘beta’ and ‘alpha’ in an equity portfolio. Broadly, beta (denoted by the Greek letter ß) captures the amount by which an equity portfolio moves with the market. So, a passive strategy which tracks the broad market (for example, S&P/ASX 200 or MSCI World) will have a beta of 1. On the other hand, alpha (denoted by the Greek letter a) captures the amount of portfolio movement not related to the market. Superannuation funds often appoint active managers to generate ‘positive alpha’; that is, returns above a pure market return. Of course, alpha can be negative, meaning the portfolio has underperformed the market. The typical way of thinking about equity portfolios is to examine the beta and alpha components which together explain the entirety of a portfolio’s performance.

The alpha/beta distinction gives a superannuation fund investor a useful choice between adopting a fairly cheap passive approach to deliver equity beta returns or adding the costs of active management to the portfolio to (hopefully) deliver extra performance through alpha.

Enter factor investing. The insight at the heart of the factor trend is that a lot of alpha can actually be explained by some common factor risks that exist across stocks. The academic literature dates back to 1976 and the most well-accepted equity factors are Value, Quality, Size, Momentum, Dividend Yield and Low Volatility. Value and Low Volatility seem to be of particular interest to large superannuation funds at present. These investors are also exploring variations like factor combinations, timing factors and tax-managed factor approaches. There are key differences in the behaviour of factor risks between the Australian and global equity markets, which investors need to understand.

Challenging the traditional alpha/beta model

Factor investing challenges the traditional alpha/beta investment paradigm because it suggests that much of what has been labelled alpha is actually returns from simple factor bets (a type of beta). A factor-based equity approach can be constructed using straightforward ‘passive-like’ rules, offering transparency and control. They can be offered in a separate account or pooled fund form, including ETFs. These investment options offer superannuation funds the opportunity to outperform the market without the costs associated with active management. Avoiding the ‘black box’ of many active management approaches is also an attraction. Factor investing is a ‘thing’ because funds realise they have three choices – alpha/factor beta/traditional beta – not just two.

Our most recent factor research identified one of the common traps funds fall into; inadvertently introducing other risks into an equity portfolio while trying to construct a pure factor exposure. We also noted, perhaps counter-intuitively, that factor investing does not ring a ‘death knell’ for active equity managers who have been important components of the equity puzzle for many funds to date. Rather, factor investing provides an opportunity for active managers to clearly differentiate themselves from mere ‘factor providers’ and to negotiate generous risk budgets with their clients to deliver true alpha based on their research and unique insights.

For superannuation funds (and other investors) who embrace the factor trend, their job is twofold: to implement a well-constructed equity portfolio that reflects their factor convictions (and, as far as possible, nothing else); and to reposition their active manager partners (and internal management teams) to harvest alpha as a true complement and enhancement to the fund’s factor bets.

 

Raewyn Williams is Managing Director of Research at Parametric, a US-based investment advisor. Parametric is exempt from the requirement to hold an Australian Financial Services Licence under the Corporations Act 2001 (Cth) in respect of the provision of financial services to wholesale clients as defined in the Act and is regulated by the SEC under US laws, which may differ from Australian laws. This information is intended for wholesale use only and not for retail clients, as defined in the Act. Parametric is not a licensed tax agent or advisor in Australia and this does not represent tax advice. Additional information is available at www.parametricportfolio.com/au.

 


 

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