Index Fund Management

A Practical Guide to Smart Beta, Factor Investing, and Risk Premia

Fadi Zaher

• Publisher: Palgrave Macmillan
• Year: 2019
• Print ISBN: 9783030193997
• eBook ISBN: 9783030194000
• Topic: Business
• Subtopic: Financial Risk Management
• Index: Business

Makes factor investing more approachable with concrete and practical real-world examples

Helps readers understand which factors have value and how to incorporate them into a portfolio

Includes ideas from academic research alongside the author's expertise as a finance practitioner

© The Author(s) 2019

F. ZaherIndex Fund Managementhttps://doi.org/10.1007/978-3-030-19400-0_1

Begin Abstract

1. Introduction: What We Talk About in Factor Investing

Fadi Zaher¹  

(1)

Index Solutions & Investment Specialists, London, UK

 

 

Fadi Zaher

Email: [email protected]

End Abstract

We do not often read about the important decision faced by investors in picking passive strategies—whether to invest in traditional index or factor investing strategies. The growth of passive investing accelerated sharply after the global financial crisis in 2008/2009. The same index strategy from various providers can have materially different outcomes. Investors considering factor strategies would benefit from some valuable lessons about the choices they are able to make and how these choices impact their investment outcomes—both positively and negatively.

This book is an attempt to write this down and focus on what matters in the hope that readers derive some comfort and confidence with factor investing. Conversations with many investors since 2008 have convinced me that there is a readership for it—including a large group of investors seeking a counterweight to the view that factor investing is doomed, and that capacity, overcrowding and the risks far outstrip the benefits.

Factor investing has grown in popularity on the back of the limitations of the traditional index strategies. Factor strategies adopt classic investment styles ranging from company fundamentals and security price behaviours, implemented through a rules-based index. The terms “smart beta”, “risk factors” or “factors” are now common and frequent in the financial press in the past few years. When the investment industry uses terms like smart beta, factor-based investing, alternative beta most of the time these terms are mainly referring to the same thing.

These factors can be described as characteristics of securities that drive the risk and reward and they exist across different asset classes. Factors are like nutrients in a diet. An asset (stock or bond) acts as a food ingredient and a portfolio is the actual meal.¹ For example, chicken, salmon or broccoli are sources of protein, but contain other nutrients such as vitamins, fibre and carbohydrates that are important for a human body to function—Fig. 1.1 illustrates this analogy with factors. Similarly, a stock can contain quality, value and other characteristics based on the financial profile of the company and price behaviours.

Fig. 1.1

Factor drivers and nutrients analogy. Source: Author, based on John Cochrane and Andrew Ang anology. Note: For illustrative purposes only

The debate on the sources of risk and reward of factor investing and the broader context within the market debate is often blurred—some are spuriously precise and unconvincing. The dominant thought in Modern Portfolio Theory since the 1950s has been that markets are efficient. The idea is that the investor is not going to be able to collect information better than the consensus—the information everybody else already has. We know today that financial markets are not always efficient—people are complex, with emotions. Empirical evidence suggested that market data or investors’ behaviour does not always support financial economic theories. If markets were fully efficient, there would be no bargains to profit from. The market’s structure—the way it is organised and trades—and collective behaviour of the marketplace make today the new era of Modern Portfolio Theory.

Over the past decade, factor investing has emerged with new funds and growing assets under management. It is among the most innovative areas of global index fund management and it continues to grow. According to Morningstar, in June 2017 there were 1320 factor-based exchange traded funds globally with total assets under management of USD 999 billion. With the sizeable institutional inflows, the factor-based assets exceed USD 1 trillion today.

There are only a few factors in the world that matter today. For factor strategies to qualify as “true factors”, they require persistent performance through time and economic rationale. The chances of discovering a new factor that is persistent has decreased in the past decade. There are limits as to what investors can do with the balance sheet and market price data. In the digital age, it is easy to data mine and come up with all sorts of factors as the cost of data mining has decreased with more publically available data technology. Before the availability of mass data and technology, people spent years gathering data and extensive programming to speed up calculations. At that time, only factor strategies based on economic principles were tested. Research on factor discoveries has revealed many of the factors as illusions. Today there are over 250 published factors with the majority being considered false factor discoveries. The decay of performance is more than 50% after the identification and publication of a factor.

Following periods of complexity in the financial markets, we often experience a back to basics mentality—a recent example is the simplification and increasing transparency of complex derivatives products such as collateralised debt obligations since the global financial crisis in 2008. The products are far simpler and more transparent today than back in 2007. However, when it comes to quantitative investment strategies, it would be foolish to deny the current complexity, abundance of investment strategies and jargon. Factor investing is different from a pure quantitative strategy. Factor investing is not necessarily a complex topic or a “black box” or deserves the complex quantitative techniques inflicted on it. The simplicity, transparency and accessibility of the main factor strategies will be discussed in various chapters.

The tendency for the public debate is often to focus on two camps—disaster or triumph—and to overlook the possibility of understanding how factor investing can help investors achieve their objective. The dissonance between academics, index machines, practitioners (the fanatics and sceptics), and media has passed to some extent unnoticed. On one side, warnings against over-optimism in passive and factor investing are commonplace: we are alerted to new passive bubbles on a weekly basis by the routine pessimists—an overdone fear. On the flip side, advocates of factor investing promise an ultimate guaranteed success—a false statement. Capital flow into strategies is a luxury problem for the fund manager, but also a curse if the underlying reason and common sense are absent from the investment thesis.

The lesson from the routine pessimists and eternal optimists is that received wisdom often creates confusion about what factor investing is, and can lead investors and decision-makers astray. One of the main messages in this book is contrary to the two camps. The main drivers for the growth in passive and factor investing is not that they are more complex nor is the money flowing in for the innovation of new factors. The main drivers are that people want to see what the simplicity and common sense of factor investing can bring to investment portfolios. With this in mind, the prospects for continued adaptation may be brighter than feared.

If we accept too easily the popular explanation for why we should invest in or avoid factor investing, without consideration of its purpose, then we may miss opportunities in achieving and understanding specific outcomes in portfolios—potential reward and risk or diversification objectives. This book aims to bring simplicity and allows embracing the topic with an open mind. It offers some perspective in the way in which the public debate is conducted, and how financial knowledge is formed and disseminated. It is human nature to complicate a topic that can have an abundance of variation when it comes to construction and outcomes. Sometimes we try too hard and end up making the wrong sort of sense of factor investing, or we infer meaning and causality where there is none. For example, trading illiquid securities to harvest a premium requires sophisticated trading capabilities or relying only on backtests to invest in a newly discovered factor. An index replication approach is unlikely to be successful in capturing this reward efficiently. The book will help readers guard against making these mistakes. It blends some of the insight of behavioural drivers, market structures and compensation for the risk that drive some of the factor returns.

There is no single definition of factor investing, evaluation tool or statistical technique that will help readers to implement this book’s central message. Instead, this book requires approaching factor investing with an open mind, and being willing to ask what it is and by whom we are being told it, and why? It also requires that readers think carefully about what they want from factor investing. This book will show how such an approach can be cultivated and will illustrate clearly its simplicity and purpose in portfolios. It will also suggest what can reasonably be expected from a typical balanced factor portfolio; what it cannot do; and the sources of factor risk-returns that make it worthwhile.

I follow and have followed my advice as an active fund manager and researcher in the topic by helping to shape the investment policy and solution for client portfolios. The aim here is to try to make sense of why a particular factor strategy is deployed and how it is constructed for a specific purpose of outcome through passive implementation. The focus is on the potential risk-reward of investment strategies that have been persistent rather than temporary without any financial economic foundations. Performance is uncertain, and fees are not. However, higher-cost active investment solutions could be the right fund choice for many investors. This choice can be the case if investors decide to delegate the investment decisions, factor selections and implementation to someone else to worry for them.

This is a practitioner’s sample of the successes and issues encountered in analysing and advising on factor investing and index strategies. My experience in asset management suggests that it will appeal to many trustees, advisors and individual savers who are interested in knowing whether factors are right for them, which factors to choose and how to implement them in the face of all that pessimism. I hope it will also be useful to many students, teachers and finance professionals as well as a wider readership. I have tried to reduce the jargon, complex equations and have tried to aim for simple and clear language in discussing the topic. References are limited to flagship research work and include those that mattered for the evolution of factor investing. Finally, I have tried to make each part and chapter of the book as self-contained as possible. The user of this book may find it useful to review and look into specific chapters, sections or read it straight through from the beginning to the end.

The ideas in this book are grounded solidly in finance and economics, but the most valuable insights are those I gained from my PhD studies at Lund University, the European Central Bank, as an investment strategist and fund manager at various financial institutions.

Part I of the book presents the case for factor investing and brings to life the good practice in building these strategies. It offers some guidance on how to take the broader perspectives that help unearth the opportunities, and are often missing from the narrower, two-camp views. It goes back to its origin, what it is and what it is not. Finally, it offers the basics of factor and index construction and illustrates exactly how the architecture of these strategies can look good. Part I also looks at efficient implementations for portfolios.

Part II sets out the main equity factor investing strategies or factors that matter and concludes with how to combine them. The main focus is on traditional factor investing strategies that have been in existence among active managers and that have made it into systematic rules-based index strategies. Among these strategies are value, momentum, quality, low volatility and small to the middle sized company investing. The aim is to provide a view of how to make sense of them, construct them and understand their limitations. Finally, Part II suggests how these can be combined and what is required for short to medium term investors and how to target long-term balanced exposure to the various factors.

Part III extends factor investing into fixed income, alternative asset classes and other financial instruments. Although potential factors in fixed income and other asset classes are not necessarily identical to equities, the principle is still to be rewarded for risk-taking and to explore market inefficiencies. The reasons why factor strategies have not taken off in asset classes other than equities are due to lack of research, historical data for bonds, liquidity, the appetite for index investment vehicles and evidence to justify a systematic approach. It is one of the most significant growth areas in risk premia strategies. This part will offer a practical and straightforward way of thinking in bonds and alternative risk premia in currencies and commodities as well.

The conclusion argues that it is worth considering factor investing. Factor portfolios should be constructed with a purpose and so avoid the potential damage of choosing a random strategy among the many options in the market, particularly within equities. The fact that many prominent academics, practitioners and investors have applied their skills to factor investing is a testament to the fascination and the interest in the subject. The discussions and debates are likely to continue in the finance industry, in academia and at cocktail parties.

Footnotes

1

This analogy has been used by two prominent academics John Cochrane and Andrew Ang.

 

Part I

Evolution of Fac...

Table of contents

• Cover
• Front Matter
• 1. Introduction: What We Talk About in Factor Investing
• Part I
• Part II
• Part III
• Back Matter