Factor Investing

From Traditional to Alternative Risk Premia

Emmanuel Jurczenko

• Publisher: ISTE Press - Elsevier
• Year: 2017
• Print ISBN: 9781785482014
• eBook ISBN: 9780081019641
• Topic: Business
• Subtopic: Finance
• Index: Business

This new edited volume consists of a collection of original articles written by leading industry experts in the area of factor investing.The chapters introduce readers to some of the latest research developments in the area of equity and alternative investment strategies.Each chapter deals with new methods for constructing and harvesting traditional and alternative risk premia, building strategic and tactical multifactor portfolios, and assessing related systematic investment performances. This volume will be of help to portfolio managers, asset owners and consultants, as well as academics and students who want to improve their knowledge and understanding of systematic risk factor investing.- A practical scope- An extensive coverage and up-to-date researcch contributions- Covers the topic of factor investing strategies which are increasingly popular amongst practitioners

1

The Price of Factors and the Implications for Active Investing

Inigo Fraser-Jenkins (Bernstein)

Abstract

The pressure on active management from the rise in passive has been known for a long time. We think that a possibly greater influence in future will be the rise of commoditized factor strategies, first in long-only equities and then for cross-asset and long–short investment. We want to make it clear at the outset that we do not want to be seen as evangelists for smart beta; it is growing and will continue to grow, not because it is so wonderful or novel or because it represents any kind of intellectual breakthrough, but because it is cheap and disruptive. Ultimately, the purpose of the asset management industry, at its most basic level, is to give return streams to asset owners. The cost of one part of this (simple factors) is declining fast, and this means that assets should be reallocated to take account of this.

Keywords

Asset managers; Efficient frontiers; Factors; Idiosyncratic returns; Multivariate benchmark; Organizational issues; Smart beta

The cost of buying exposure to simple factors in the so-called smart beta format is rapidly declining. On one level, this raises the bar for all active managers (both fundamental and quant), but it also makes it easier to determine which kinds of returns investors should pay an active premium for. The price of buying smart beta is rapidly converging on outright passive rates, but at the same time this highlights that buying a smart beta index is an active act of asset allocation. When smart beta indices have a fee close to that of traditional indices, then they implicitly become benchmarks. This causes a profound shift in asset management: the progression from a univariate to multivariate benchmark. In such a world, the goal of active management becomes generating idiosyncratic returns.

1.1 Introduction

The pressure on active management from the rise in passive has been known for a long time. We think that a possibly greater influence in future will be the rise of commoditized factor strategies, first in long-only equities and then for cross-asset and long–short investment. We want to make it clear at the outset that we do not want to be seen as evangelists for smart beta; it is growing and will continue to grow, not because it is so wonderful or novel or because it represents any kind of intellectual breakthrough, but because it is cheap and disruptive. Ultimately, the purpose of the asset management industry, at its most basic level, is to give return streams to asset owners. The cost of one part of this (simple factors) is declining fast, and this means that assets should be reallocated to take account of this.

The growth of commoditized factors changes the asset management industry in a number of ways. In the end, it blurs the active–passive distinction and makes it difficult to say where one starts and the other ends, to the extent that active managers were offering return streams that looked a lot like factors. As such these cheap factor strategies offer a way to cut costs and should grow. We suggest that the price of commoditized factors will continue to fall. When the price of factors approaches the cost of buying the traditional cap-weighted passive index, a fundamental change occurs. At that point factors become plausible alternative benchmarks. What this does is essentially move the basis for assessing active managers. Historically the benchmark for nearly all funds has been a single index; we suggest the arrival of factors at close to zero fee makes the benchmark for all funds multivariate. This might sound like a nightmare for active managers, but actually we think it provides the basis for finding a core of active funds that are genuinely needed by investors. The measure for activity becomes idiosyncrasy. If a fund delivers returns that are idiosyncratic to the available set of commoditized factors, then it is probably important for the asset owner.

There is, however, a massive Achilles heel for smart beta. Who should get the job of allocating to these factors? This is essentially an act of asset allocation and is unambiguously active. Indeed, it can span asset classes. In a world where asset class returns are low and asset class correlations rise, the role of asset/factor allocation arguably becomes more important anyway. For most asset owners the ultimate benchmark is a liability set in the real world. Seen in that light, any allocation to a factor index or cap-weighted index is active. Thus for many investors, as factors become commoditized, the critical active factor question that they will face will be how to allocate to the factors rather than necessarily the best way of defining a given factor.

1.2 Smart beta: the Uber of asset management

At its simplest, commoditized factors allow for a cheap replication of some of the style factors that have been used by active fund managers to drive outperformance over the last 20 years. The “passive” replication of these factors by, for example, smart beta exchange traded fund (ETFs) provides a service for asset owners in lowering the cost for something that they no longer need to pay a full active asset management fee for. We believe that the best way to think about smart beta is as the Uber of fund management. It is potentially one of the main disruptive forces in equity investment, and its effects are likely to soon be felt in other asset classes too. It lowers costs for investors and democratizes access to a range of investment returns.

We should say upfront as a point of definition that we hate the phrase “smart beta”. We have a lot of sympathy with Montier’s pithy equality of smart beta = dumb alpha + smart marketing [MON 13]. We do not want to be mistaken for evangelists for a smart beta approach. We also do not really care what it is called. We use the expressions alternative beta, strategic beta and exotic beta interchangeably, but we use the term “smart beta” here as that seems to be the most common one in use. It is just a marketing label. Smart beta is not going to grow because it is so good. The strategies used in smart beta are akin to active quant circa 1995. Nevertheless, smart beta is going to grow because it is so cheap. And it is becoming cheaper. In Figure 1.1, we show that the headline fees for smart beta are halving every year. In this case, we show the cheapest mainstream rate rather than an average across products.

Figure 1.1 Falling cost of smart beta: halving every year

Here, we are taking a particular strand of smart beta, which is long-only, equity, US, ETF-format smart beta. But that is a large strand and anyway, the pattern holds elsewhere. This particularly strikes a chord in markets such as the United Kingdom and Australia, where fees have become the key issue above all others.

Smart beta has grown fast over the last 5 years, and we now estimate that within equities, it accounts for $500 billion–1 trillion of AUM. Although smart beta is large and growing fast, a lot more work is needed. We think we need to be explicit about what we need and what we do not need for the development of this area (see Table 1.1).

Table 1.1

Smart beta: what we need and what we do not need

What we need	What we don’t need
A process for strategic allocation to smart beta	Yet another new smart beta product launch with a new strategy or new weighting scheme. PLEASE, NO MORE INDICES.
A classification of smart betas	Another academic paper on why smart beta approach N will work because of behavioral bias X.
A measure of success of a given strategy	Please deliver us from consultants determining the allocation to these products.
A better name	Agonizing about whether they are active or passive. Who cares? The distinction is dead anyway.

Source: Bernstein analysis.

Perhaps the most work needs to be done in the allocation process across smart beta. We do not necessarily mean dynamic or tactical switching: yes, we do see a growing appetite for that, but such tactical approaches will always be in the minority as proving skill at timing is hard. What is of more urgent need is a way of making a strategic or structural allocation to smart betas. At the moment, this is a mess and one of the areas we think most likely to give smart beta and quant in general a bad name. We see many cases where the investment in an often univariate smart beta strategy is pitched as a replacement to an active mandate with the aim of significantly lowering the fee. It may well be the right thing for an investor to replace a more traditional active mandate with a collection of smart beta funds, but moving to one smart beta probably makes a very significant change in factor allocation. We worry that end-investors at smaller institutions may not fully realize this. We worry more when this process is intermediated entirely by consultants as the evidence from academia implies that they may not be the best suited to make active allocations such as these [JEN 16]. The solutions teams of asset mana...

Table of contents

• Cover
• Title page
• Table of Contents
• Copyright
• Foreword
• Acknowledgements
• Introduction
• 1: The Price of Factors and the Implications for Active Investing
• 2: Factor Investing: The Rocky Road from Long-Only to Long-Short
• 3: Peering under the Hood of Rules-Based Portfolio Construction: The Impact of Security Selection and Weighting Decisions
• 4: Diversify and Purify Factor Premiums in Equity Markets
• 5: The Predictability of Risk-Factor Returns
• 6: Style Factor Timing
• 7: Go with the Flow or Hide from the Tide? Trading Flow as a Signal in Style Investing
• 8: Investment and Profitability: A Quality Factor that Actually Works
• 9: Common Equity Factors in Corporate Bond Markets
• 10: Alternative Risk Premia: What Do We Know?
• 11: Strategic Portfolio Allocation With Factors
• 12: A Macro Risk-Based Approach to Alternative Risk Premia Allocation
• 13: Optimizing Cross-Asset Carry
• 14: Diversification and the Volatility Risk Premium
• 15: Factor Investing and ESG Integration
• 16: The Alpha and Beta of Equity Hedge UCITS Funds: Implications for Momentum Investing
• List of Authors
• Endorsements
• Index