Making sense of factor investing

Return enhancement, risk reduction and lower costs are the primary objectives for the use of smart beta. But what is smart beta and why does it matter?

Return enhancement, risk reduction and lower costs are the primary objectives for the use of smart beta among institutional investors, according to a recent global survey. These results also reveal that smart beta has become an increasingly strategic allocation among larger investors. But what is smart beta and why does it matter?

A dear child has many names, and smart beta is one of these “children”. Product providers confuse investors with terms like factor investing, smart beta and risk premia among others. These are closely related but with some differences.

Smart beta is just a type of factor investing. More than ten years ago the term described funds or indexes with a “smarter” diversification than the broad market index. Today it usually refers to equity investment strategies with a factor tilt combined with an efficient diversification. For example, a fund that invests into low volatility companies will have equity risk but with a tilt to the low volatility factor.

So factor investing simply defines the investment style of smart beta or other factor products. It also embodies factor products in fixed income markets, or strategies which invest in a market-neutral way into different factors across many asset classes.

We need to acknowledge smart beta, because most investors are exposed to factors in one way or the other. Unknowingly, the factor exposure of the portfolio might be very biased or unfavorable to the investor’s objectives or liabilities.

Academic foundation

Factors are academically well-documented return premiums associated with certain characteristics of securities. Numerous factors have been discovered, but only a handful of them have won general approval from the academic community and show robust empirical results through time. For example, it has been shown that a few factors can explain equity market returns. In addition to size and value (Fama and French, 1992), other widely approved factors are momentum (Jegadeesh and Titman, 1993), quality (Novy-Marx, 2013) and low volatility (Black et al., 1972).

Many factors are rewarded, due to being exposed to a certain type of risk during bad (economic) times – hence they carry a risk premium. An investor willing to hold this risk gets compensated (receives a factor premium). It has been suggested in much of the academic literature that investors capable of bearing these risks should harvest these factor premiums (see e.g. Ang (2013)).

Why do factors outperform in the long run?

As a general rule, there are two types of explanations. According to the risk-based theory mentioned above, outperformance is based on risk premiums. According to another approach, the outperformance of factors is explained by the irrational behavior of investors – their psychology often makes them susceptible to systematic errors in investment decisions. Both approaches are at least partially correct and not mutually exclusive.

Harvesting factors

Investors can harvest factors by getting a tilt towards them along with traditional market risk (equity risk), or you can invest into them in a market neutral way by shorting away the market risk or the anti-factor, and collect the premium(s). This type is often called alternative risk premium investing.

Multi-factor simply means that you combine more factors than one into a portfolio. Multi-factor investing focuses on the factors that have been shown to outperform and minimizes exposure to risks that underperform over the long-term.

The low correlation between factor returns implies that by diversifying between them, the probability of underperformance decreases significantly. In addition to the superior return profile offered by equity factors, efficient diversification is another vital element. While broad market indexes are often considered well diversified, factor investing usually offers enhanced diversification.

Factors do matter

Most of the academic literature agrees on the empirical findings that factors explain much of the risks and returns in equity markets. Hence it makes sense for long-term investors to exploit these factor premiums.

Diversification is often said to be the only free lunch in investing. Due to the cyclical nature of the factors, and the low correlation between them, it is wise to diversify between many factors.

Investors can harvest factors in a cost-efficient way by investing into multi-factor products or indexes. Traditional passive market-cap based indices are cost-efficient, but they possess an incomplete diversification and often give you a high exposure to non-rewarded risks, like large-cap stocks. Hence, factor indices have a better exposure to rewarded premia, as well as a more efficient diversification than broad market indices.

Investors need to address the systematic risks that drive their portfolio returns. Some of these risks might be unrewarded. Minimizing the exposure to these unrewarded risks and tilting the portfolio to factor premiums is desirable for investors who are looking to improve portfolio returns in the long run.

Text: Peter Lindahl

Peter Lindahl, M.Sc. (Econ.), member of Evli’s allocation team and the Head of Multi-Asset at Evli. Peter has worked in the finance industry since 1996 and started at Evli as a portfolio manager in 2000. He and his team manage multi-asset and factor funds. 

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

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