Five things about maximizing factor investing performance

For professional investors

Five things about maximizing factor investing performance PIONEERS IN FACTOR INVESTING

Although factor investing is becoming more popular, there are still plenty of questions surrounding the concept and its implementation. In Europe, the US and Asia, it is a widely debated strategy within the professional investment community. Investors are attracted by the prospect of greater diversification, higher returns and lower risk. What should investors know in order to maximize their factor investing performance?

What is factor investing?

Factor investing is a systematic approach to investing in the parts of the financial market that realize better performance over longer periods than other segments. Some examples of these factors are: – Value: the tendency for inexpensive stocks to generate above-market returns. – Momentum: stocks that have performed well in the recent past will continue to do so in the future. – Low volatility: stocks that are less risky have higher risk-adjusted returns.

Here are five things that every investor should know.

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Five things about maximizing factor investing performance

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’Factor investing is not hype’ The popularity of factor investing is on the rise: assets under management are set to increase.

Research provider Spence Johnson estimates that the mutual fund market for factor investing in Europe will increase from EUR 132 billion in 2014 to EUR 340 billion in 2019. So interest is increasing. But if you consider factor investing more carefully, it isn’t compatible with the standard definition of hype.

Factor investing is not hype, it’s here to stay. Hype has little to do with reality, while the basis for factor investing lies in decades of accumulated academic research. There is a large body of empirical literature supporting the existence of factors. Research on the low-volatility factor started back in the 1970s, while most of the empirical research into the value and momentum factors was completed in the 1990s.

Hype is also short-lived, while factor investing has been slowly gaining ground over the years.

A worldwide crisis was needed to boost the adoption process: the global financial crisis of 2008. The breakthrough only came after the publication of a research report in 2009 by professors Andrew Ang, William Goetzmann and Stephen Schaefer, advising the Norwegian government to strategically allocate to factors. The three professors were asked to investigate the disappointing performance of one of the world’s largest sovereign wealth funds, which invests Norway’s oil revenues.

It turned out that the fund’s performance could largely be explained by its exposure to a small group of factors, something that its managers were not aware of at the time. Although it appeared to hold a wide range of different asset classes, the exposure they created for the portfolio was not well diversified at all. The idea of factor investing then started to become more popular among professional investors around the world who were faced with similar diversification issues. Since then, growing numbers of leading institutional investors allocate part of their portfolio to factor investing.

Five things about maximizing factor investing performance

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’Invest in the proven factors’ Value, momentum and low volatility – for which there is ample academic evidence – work better than the latest factors that are backed by less research. This was one of the findings

by Robeco’s Head of Factor Investing Research Joop Huij, who examined the data of approximately 7,000 funds over a twenty-year period from 1990 to 2010.

His goal was to find out whether active managers who applied factor-based investment strategies consistently outperformed their benchmarks. His conclusion was that the most wellknown and well-researched factors – value, momentum and low volatility – worked best, while the newer, more exotic factors did not offer higher returns and their performance was poorer.

Why do these more exotic factors perform less well? Many studies on new factors use simplified scenarios. For example, there are no trading costs, it is as easy to trade in small caps as it is in large caps, or there are no taxes.

The factors that do work have two things in common: there is ample empirical evidence for their existence and it is underpinned by economic rationale. Huij found that the best mutual funds benefit from proven factor premiums. So rather than being on the lookout for the latest factors, you should select the more common and well-researched ones instead.

Skeptics argue that the premiums of the common factors may disappear at some point in the future due to increased popularity. In theory, the extra returns might disappear if every investor adopts this approach. But this scenario is unlikely, although factor investing will become more widespread. Even the most optimistic expectations predict that not all investors will be willing and able to implement it. This has to do with conservatism in the industry and organizational structure – most investment strategies are based on market-cap weighted indexes and this is not likely to change anytime soon.

Indeed, most factor strategies are tiny in absolute terms. For example, low volatility, one of the most popular factors, only accounts for 0.5% of the total US stock market capitalization1. So the fact that assets under management are set to grow should not jeopardize the future of factor investing in the coming years.

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David Blitz and Pim van Vliet, ‘Are low-volatility stocks overcrowded?’, Robeco Research Paper, November 2014

Five things about maximizing factor investing performance

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‘Factor premiums are not the result of taking higher risks’ Robeco research shows that the view that factor premiums are a reward for risk does not necessarily hold true. Take value stocks: a widely held view is that these stocks are cheap for a reason, because they are more risky for investors. The existence of this premium is typically attributed to a higher distress risk and the theory is that returns on value stocks should rise because the risk increases.

Robeco research found that although a conventional value strategy can indeed involve large exposures to this risk, it is not necessary to run this risk. You do not need to invest in high-risk stocks to capture the value premium, because the value premium is caused by mispricing. Therefore, a more sophisticated value strategy can be designed to avoid unrewarded risk.

Graph 1 shows the result of including credit spreads as an indication of distress risk in a simple value strategy based on the book-to market ratio (B/M). Including credit spreads when selecting stocks increases returns for all five groups. The most attractive stocks (high B/M) have a low valuation and have low distress risk.

Graph 1: Higher returns by including credit spreads in a simple value strategye Relation return, value and distress risk US 1991 - 2009* 20% 16% 12% 8% 4% 0%

Value (High B/M) Low credit spread

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Growth (Low B/M)

High credit spread

Source: De Groot & Huij, “Is the Value Premium Really a Compensation for Distress Risk?”, SSRN working paper no. 1840551

The Robeco value stock selection process includes criteria to avoid high distress risk, poor financial strength and companies with an aggressive accounting base. Or in plain English: we take the rotten apples out of the value basket and still earn the value premium. This allows us to reduce risk without sacrificing returns.

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’An enhanced factor approach leads to a higher performance’ Investors can chose choose indexes to get factor exposure, but an enhanced factor approach leads to higher performance. Factor indexes, often referred to as smart beta indexes, offer systematic exposure towards factor premiums through alternative weighting schemes.

However, they are not designed to harvest factor premiums in the most efficient manner, but primarily for simplicity and appeal.

Table 1 shows the return and volatility characteristics of three factor indexes. These indexes are efficient in capturing factor premiums: all realize a better return-volatility profile than the market-cap weighted index, the MSCI World Index.

Table 1: Return and volatility of factor indexes versus the market-cap weighted index

Return Volatility Return/volatility

MSCI World

MSCI Value

7.6%

9.4%

MSCI Momentum 10.7%

MSCI Low vol 8.1%

15.3%

15.5%

15.8%

11.4%

0.50

0.61

0.68

0.71

Source: Blitz, Huij, Lansdorp & van Vliet (2014), ‘Efficient factor investing strategies’, Robeco whitepaper. The sample covers the period June 1988 to December 2013. Returns are in USD. Robeco factor strategies are based on portfolio simulation and net of conservatively estimated transaction costs

A more sophisticated approach realizes even higher better return-volatility profiles, as can be seen in table 2.

Table 2: Return and volatility of an enhanced approach versus the market-cap weighted index MSCI World Return Volatility Return/volatility

Value +

Momentum +

Low vol +

7.6%

13.4%

12.8%

12.2%

15.3%

15.4%

15.4%

11.6%

0.50

0.87

0.83

1.05

Source: Blitz, Huij, Lansdorp & van Vliet (2014), ‘Efficient factor investing strategies’, Robeco whitepaper. The sample covers the period June 1988 to December 2013. Returns are in USD. Robeco factor strategies are based on portfolio simulation and net of conservatively estimated transaction costs

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Five things about maximizing factor investing performance

We see three main pitfalls related to using indexes that investors should avoid.

Avoid taking extra risk without generating extra returns Extra risk does not always generate extra returns. For example, stocks with a higher risk of distress deliver lower returns. Our main concern about conventional value strategies such as fundamental indexation is that these are tilted towards firms with a higher distress risk.

Investors should never forget that some stocks are simply cheap for a reason.

Investors should avoid stocks with deteriorating financial health not only when selecting attractive value stocks, but also when looking for good low-volatility or, better said, low-risk stocks. This, for instance, results in smaller peak-to-trough declines.

Avoid going against other factors Creating positive exposure to one factor may result in negative exposure to other factors. This is undesirable as it can lower the expected return.

Take momentum and value for example. One concern in a value approach is buying too early.

A stock may seem to be attractive from a value perspective due to its poor momentum. But if its price continues to decline it isn’t an attractive stock to have in a portfolio.

Efficient factor strategies should therefore be designed in such a way to prevent premiums from going against each other and thereby affecting performance.

Avoid strategies with high turnover Investors should avoid strategies with too high turnover because this has a negative impact on performance. Trading costs are not limited to commission; they also include bid-ask spreads and market impact. These costs are an important consideration, especially in the case of momentum strategies that by definition have relatively higher turnover.

A conventional momentum strategy requires high turnover and therefore naive trading rules lead to significant trading costs. This may involve, for instance, buying a stock ranked just above the selection threshold and selling it again at the next rebalancing, three months later, if its rank has dropped below the threshold. More sophisticated buy-sell rules help avoid unnecessary turnover, resulting in higher returns after costs are taken into account.

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’Diversify over multiple factors in your portfolio’ While key single factors have been shown to outperform over long periods, they have all experienced periods of underperformance relative to a cap-weighted benchmark. These periods of relative underperformance can range from two to six years – longer than the patience of many investors.

The best way to cope with these periods is to diversify across factors: it is desirable to always have a winning factor when other factors underperform. The importance of diversification can be seen in graph 2 below. For example, in 1998 and 1999 momentum stocks did well when value and lowvolatility both struggled.

Value+

Momentum+

2014

2012

2010

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

Graph 2: Diversification over multiple factors is crucial to success Years when Robeco factor strategies outperformed*

Low vol+

Source: Robeco Research

The improved return-volatility profile of an equally weighted factor portfolio of Robeco’s enhanced factor strategies can be seen in table 3.

Table 3: Return and volatility of MSCI World versus an Equally Weighted Portfolio Index Return Volatility Return/volatility

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Five things about maximizing factor investing performance

MSCI World

Equally Weighted Portfolio

7.6%

12.80%

15.3%

14.13%

0.50

0.92

There are clear benefits in diversifying across factors. But how difficult is it to implement?

Implementing multiple factors simultaneously does not have to be difficult. Investors can themselves combine single factor strategies, but the easiest option is to choose a fund that offers diversified exposure. A fund can incorporate an efficient implementation, including monitoring exposure and rebalancing. In addition to a fund, mandates can be specifically tailored to investor needs and preferences.

The best mix of factors is client specific and depends on investment goals. For example, liability driven investors with greater risk aversion and sensitivity to capital loss may want a tilt towards a low volatility factor. Longer horizon defined contribution schemes with higher growth objectives may favor a tilt towards momentum and value factors.

Investors currently evaluating factor investing are more focused on using multiple factors than those who have implemented it in the past: leading institutions and other professional investors are integrating it into their portfolios.

Using multiple factors at the same time can also be applied in markets other than equites. In a recent study on which a working paper was published last year, Robeco researchers illustrated that factor strategies can also be attractive in credit markets.

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More about us Robeco was one of the first companies to see the potential of factor investing and to embrace it at an early stage. Since 1994, the Robeco Quantitative Research team has concentrated on analyzing, evaluating and designing various factor strategies. Persuaded by the academic evidence in favor of factor investing, it has conducted its own research to develop workable strategies.

For Robeco it is very important to know more about why factor premiums exist. A more in-depth understanding can enable you to gain a better exposure to them. Our research has shown that it is crucial to understand the source of a factor premium.

In 2006 Robeco launched Conservative Equity strategies to capture the low-volatility premium for equities. Since then we have introduced further single and multifactor strategies and solutions for equity and credit markets. The company works closely with leading universities in the fields of finance, economics and econometrics.

Find out more at www.robeco.com/factorinvesting

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Five things about maximizing factor investing performance

Disclaimer Robeco Institutional Asset Management B.V., hereafter Robeco, has a license as manager of UCITS and AIFs from the Netherlands Authority for the Financial Markets in Amsterdam. Without further explanation this document cannot be considered complete. It is intended to provide the professional investor with general information on Robeco’s specific capabilities, but does not constitute a recommendation or an advice to buy or sell certain securities or investment products. All rights relating to the information in this presentation are and will remain the property of Robeco. No part of this presentation may be reproduced, saved in an automated data file or published in any form or by any means, either electronically, mechanically, by photocopy, recording or in any other way, without Robeco’s prior written permission. The information contained in this publication is not intended for users from other countries, such as US citizens and residents, where the offering of foreign financial services is not permitted, or where Robeco’s services are not available.

Five things about maximizing factor investing performance

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