Factor investing – already too popular?

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Up to 60 % of the institutional investors in Europe have made allocations to smart beta products. At least according to the respondents of FTSE Russell’s recently published annual Smart beta investor survey. The share of European institutions investing in smart beta has grown steadily from 40% in 2015 and 52% in 2016. 

European institutions have led the pack in allocations to smart beta, while the North-American and Asian peers have been slower in adopting smart beta strategies.

In recent times some investors have started to voice concerns over the popularity and the resulting crowdedness of smart beta investments (most notably about low volatility products). If investors pile more and more assets to smart beta (or factor) investments, can the excess returns persist? This is a question worth a revisit from time to time amid reports of ever increasing popularity of smart beta investments.

Excess returns from investing into factors (smart beta) are usually seen to be either the result of a rational risk premium or an anomaly arising from investors’ systematic errors (or a little bit of both). If factor returns are explained by additional risk, the premium is highly unlikely to disappear completely (we do still have the equity risk premium, for example). The factors with only behavioural explanations could in theory be arbitraged away with little if any premium remaining to be harvested (who wouldn’t like more returns for the same risk?).

Factor strategies have a strong real-life track record

However, we find it very unlikely for factor premiums to erode completely. First of all, most of the factors –  be either risk- or anomaly based – have been formalized decades ago (and practiced implicitly by active investors for much longer still) but have still continued to work.  A paper recently published in the Journal of Portfolio Management studied the long-term track records of factor-based investment strategies. The authors found that value, size, momentum and low volatility strategies have continued to offer significant excess returns globally in most of the stock markets also in the 21st century – even as they were familiar and accessible to any interested investor.

So, clearly investors’ knowledge about factor based strategies hasn’t been enough to erode the premiums. Of course, as the above survey tells us, only recently have systematic factor strategies gained widespread traction among institutional investors. Might this then be enough to make the factor premiums disappear in the near future?

Allocation to smart beta is still relatively small

We think not. In spite of the rapid growth in assets invested passively, the amount of assets in active investments still remains higher by orders of magnitude. Of the assets invested passively, only a small amount is invested in smart beta or factor products. It has been estimated that of the $6 trillion or so of passive investments (around one tenth of the total market capitalization of listed equities), 10% is invested in smart beta products.

David Blitz of Robeco studied ETFs’ positioning regarding factors. He found that on aggregate ETFs are not exposed to factors. While there are smart beta ETFs (and other ETFs that implicitly take on factor exposure), these are offset by other ETFs taking the opposite side of the trade. ETFs are not long on aggregate even in the low volatility factor, where potential crowdedness has been of most concern to investors. Thus it seems, at least ETFs are not making factors crowded.

There would have to be an enormous increase in assets invested in factor products for the premiums to be strongly affected. And even if this was to happen, the current investors would be the ones to reap the benefits from increases in valuations caused by the new allocation flows.

Considering the elevated valuation levels (and thus, lower expected returns) of traditional asset classes, it makes more sense than ever for investors to look for alternative sources of additional return. Investing in factors is a proven way of finding it.

Talking of factors’ return persistency, AQR’s Cliff Asness’ great blog post from 2015 is always worth a read.

There is more to it than the returns

On top of looking for additional returns, investors are getting more conscientious about socially responsible investing and ESG. In the smart beta survey a full 60% of European respondents (who had invested or were planning to invest in smart beta) anticipated applying ESG considerations to the strategies.

The investors’ interest is easy to understand. Many institutions have recently outlined policies regarding the carbon footprints and other ethical aspects of their investments. Factor investing – with its systematic nature and extensive diversification – is a natural candidate for applying these kinds of filters to. ERI Scientific Beta’s research shows that factor indices with low-carbon filters applied have generated at least as strong returns as normal factor indices, but with a significantly lower carbon footprint. In this light it makes all the sense for investors to choose factor investing to help them meet their ethical goals, while also earning some excess returns.

So what do the investors want

All in all – we do not think factor investing is even close to being too popular, but will continue to offer a great opportunity for investors for years to come. Institutional investors seem to agree. Another smart beta survey by EDHEC found that 94% of the respondents aim to increase their allocation to smart beta products.

Setting aside the ESG considerations, what else are the investors looking for in the smart beta products they invest in? EDHEC’s respondents felt the strongest requirement for factors they would invest in was that they be extensively documented in empirical literature. Other important considerations were for factors to be risk-based (not only behavioural), easy to implement with low costs, and have simple definitions.

The top two motivators (for the respondents of both surveys) for choosing to invest in strategies were risk reduction and return enhancement, while cost-efficiency was also seen to be fairly important.

So according to institutional investors, the smart beta products that will probably see more inflows in the near future will be those that use simple, well documented factor definitions, are cost-efficient, offer excess returns and better diversification, as well as include elements of ESG investing.

 

Interested in further reading? Download the white paper The Case For Equity Factors