The factor investing revolution

The factor investing revolution: Are you up for the challenge?

PIONEERS IN FACTOR INVESTING

Factor investing has been around for many years, but it remains challenging to some investors. Although it is based on the complex world of quantitative investing, its core technique is actually very simple: using specific characteristics to construct portfolios to gain a premium in stocks or bonds. And it has been proven to work in generating alpha (profits above those of the benchmark index) while also improving the Sharpe ratio, a metric which measures how much the return of an asset compensates an investor for the risk taken.

Once they are shown how they can generate better riskadjusted returns by joining the factor investing revolution, investors are increasingly allocating their investments to factors. This is making what was once a specialized technique in the 1990s a more mainstream strategy two decades later in the 2010s. But how does it work?

What are these factors, and how does targeting them add returns, given that all markets go up and down?

Value

There are four major factors that Robeco follows in creating multi-factor portfolios. For equities, these are Low-Volatility (Low-Risk), Value, Momentum and Quality.

For corporate bond portfolios, the fourth factor of Quality is replaced with Size. The factors work like this:

Momentum

Low-Volatility Studies show that equities or corporate bonds with lower risk, due for example to the stability of the company, earn higher risk-adjusted returns. It means equities with lower volatility can earn the same risk-adjusted returns as those with higher volatility, sparing the investor the need to take on the extra risk. This principle also works in the corporate bond market, where companies get a credit rating, from super-safe AAA down to much riskier CCC. Historically, portfolios of shorterdated and higher-rated bonds have enjoyed higher Sharpe ratios than the rest of the market.

The Value factor targets companies whose share or bond price is deemed to be lower than the fundamentals of the company would suggest. This is often caused by overreactions to news, so that mispricings arise. This creates potential upside in undervalued equities or bonds, creating the Value premium.

This follows the proven notion that past winners tend to be future winners and similarly, that past losers tend to be future losers. Put simply, companies with share or bond prices that have consistently outperformed are likely to continue to outperform, and conversely the underperformers usually continue to underperform. Selecting those companies that display such Momentum creates a premium.

Quality The Quality effect is the tendency of high-quality stocks to outperform low-quality stocks and the market as a whole.

What constitutes ‘quality’ however is less well defined than other factors. As a rule, high-quality companies are typically either highly profitable or are conservatively managed. Other characteristics such as safety and growth, have also been linked to the Quality premium. Because the definitions can be vague, and use of this factor is still relatively new, we advise allocating less to this factor than to the others at present.

Size Smaller companies tend to be ignored by many investors, who typically aim to efficiently cover a large percentage of the market capitalization of the index using a limited number of analysts. From that perspective, larger companies are more efficient to cover than smaller companies. This lack of attention for smaller companies, as well as their lower liquidity, creates a premium directly related to their size.

Harvesting these factor premiums Robeco has been a pioneer of quantitative investing, embracing and developing it since 1994, when the Robeco Quantitative Research team first began to use various factor strategies. The first factor fund came along in 2006 when Robeco launched the Conservative Equity factor investing strategy. Since then the company has introduced further single and multi-factor strategies and solutions for equity and credit markets.

“One of the benefits of adopting factor investing is that it follows a systematic, rules-based approach to harvest a specific premium, and thereby takes some of the human frailty or emotion out of picking stocks,” says long-time quantitative researcher and portfolio manager Patrick Houweling, Manager of the Robeco Global Multi-Factor Credits fund.

“Such behavioral biases can include a natural inclination to pick stocks or bonds of growth companies or of more risky companies, believing that these will perform better than others, when in fact they can be relatively expensive, limiting the potential upside.”

However it is important to use all four factors together, rather than focusing on just one. For one thing, just using a single factor such as Value might result in the portfolio underperforming in turbulent times when investors seek ‘defensive’ companies such as Utilities which can sometimes be quite expensive. For another, some factors can counteract others; a stock or bond which exhibits Value may not have Momentum, or a pick based on Size can then fail the LowRisk test. Building such a multi-factor portfolio makes the alpha it is able to generate more stable over time. The multifactor portfolio is able to retain the high Sharpe ratio of the individual factors, but with smaller drawdowns and lower tracking error versus the market.

Evaluating the factors Buying those securities which have all four characteristics usually results in superior returns – so how to find them?

Robeco uses data sets going back over many decades and then builds models where theory can be tested before it is put into practice in a real portfolio.

PATRICK HOUWELING FUND MANAGER OF THE ROBECO GLOBAL MULTI-FACTOR CREDITS FUND

“Every month we give each corporate bond in our investment universe a score on each of the factors, and the total score over all factors determines the attractiveness of the bond.”

Although most factor research focuses on the equity market, the concept and benefits of factor investing apply equally well to the bond market, including the credits that Houweling and his colleagues buy. “It can therefore be a persuasive argument if an investor is already using factors in an equity portfolio and is wondering how it would work in corporate bonds,” says Houweling. “Our research and experience shows that the same principles apply as in equities, making it an ideal investment strategy in most market conditions.”

And don’t forget that a very important component of fund management lies in portfolio construction, particularly in

knowing when to buy and sell, which can add value in itself.

“Besides smarter factor definitions, the portfolio construction rules can also be made smarter to enhance performance,” says Houweling. “For example, we wouldn’t necessarily immediately sell a security if it dropped out of one of the factor criteria, because to do so would create excessive transaction costs. It is often more prudent to wait a bit longer and earn somewhat lower alpha than immediately selling and incurring the costs.”

Diversification is another important element of portfolio construction. “Large sectoral and regional bets should also be avoided. For instance, a generic Value strategy in 2007 would have mainly bought financial company bonds as their credit spreads widened and they became relatively cheaper, but in 2008 this would have led to a large drawdown when the financial crisis began. Limiting the portfolio weight of a single sector prevents concentrated positions, and improves the diversification of the portfolio. Factor investing is about efficiently harvesting premiums, and not about taking bets on individual sectors or companies.”

Golden rules for success Not taking bets means following the rules and relying on solid research: a guiding principle and philosophy that has been at the bedrock of Robeco’s strategy since its founding chairman Lodewijk Rauwenhoff said in 1929 that “every investment strategy should be research driven”. The factors are proven to work thanks to decades of research, and investors won’t be disappointed if they stick to some golden rules, says Robeco’s Head of Equity Factor Investing Research, Joop Huij.

Firstly, invest in the proven factors: Value, Momentum, Low-Volatility, Quality and Size – for which there is ample academic evidence – work better than newer factors that are backed by less research. This was one of the findings by Huij, who examined the data of approximately 7,000 funds over a 20-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 well-known and well-researched factors worked best, while the newer, more exotic factors did not offer higher returns, and their performance was worse. 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

LODEWIJK RAUWENHOFF FOUNDING CHAIRMAN

“Every investment strategy should be research driven.” factor premiums. So rather than being on the lookout for the latest factors, you should select the more common and wellresearched ones instead. While Huij’s research was based on equities, this premise also holds true for bonds.

Secondly, ignore anyone who tells you that factor premiums are the result of taking higher risks, and that’s why you get a premium. This is a common myth: Robeco research shows that this notion does not necessarily hold true. Take value stocks: a widely held view is that they are cheap for a reason – because they are riskier 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. 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.

JOOP HUIJ HEAD OF EQUITY FACTOR INVESTING RESEARCH

“The factors are proven to work thanks to decades of research, and investors won’t be disappointed if they stick to some golden rules.”

Thirdly, investors should understand that an enhanced factor approach leads to a higher performance. Factor indices – often referred to as smart beta indices – 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 are primarily used for simplicity and appeal. This means they have inherent pitfalls. For example, stocks with a higher risk of distress due to the worsening financial health of the company would tend to deliver lower returns.

Even if such a stock was attractive from a value perspective, it would have poor momentum, making the multi-factor approach more desirable. And some index-based strategies have a very high turnover due to the need to track the index, which can have a negative impact on performance due to potentially high trading costs.

A ‘third way’ between active and passive There is a wider issue with the growth of factor indices, or any market indices for that matter: the growth of passive investing. One thing that deters investors from pure factor investing is the fact that it does form part of active management, and that in itself has been under fire since the financial crisis, when many actively managed funds underperformed benchmarks or lost money altogether. Many investors have since chosen to cut out the middleman and follow the index directly instead, using tracker or ExchangeTraded Funds (ETFs) as their vehicle. This was cost-effective for many investors, since active managers charge a higher fee for their services than passive managers, who require only the means to track and index, with no research involved.

“The real problem with passive investing is that it is a ‘wartsand-all’ strategy; you get the poorly performing stocks along with the stars, with no means of filtering out the winners and losers.“ This is primarily because different types of stocks have vastly different performances; ‘growth’ stocks, for example, can earn more during boom periods, but they are much more volatile, and can also lose more when they fall out of favor. So can factor investing bridge the divide as a ‘third way’ between active and passive investing? Yes. The style often does serve as a half-way house between active and passive, since it uses a systematic approach to investing in the parts of the financial market that realize better performance over longer periods than other segments.

“Active management can be rewarding but risky, while passive investing is inefficient; a portfolio simply invests in all stocks, including the unattractive ones as well as the attractive ones,” says Huij.

“Factor investing can act as a third way in constructing a portfolio.” There are two ways of doing this, he says. Thanks to the growth of the investment style, each of the factors that Robeco now follows in equities has its own benchmark index (corporate bonds, as yet, does not). Fund managers can therefore base their portfolio construction on the indices for Value, Momentum or Low-Volatility that now exist in the market, but as we have seen in the example above, this can lead to downsides. The alternative, and better way is to start from scratch and use the factors on a bottom-up basis, says Huij. “We prefer to implement factor investing using our own proprietary models and processes, so this is the way that our factor funds are constructed,” says Huij.

Competing in the Champions League This is all fine in theory – but are investors convinved in practice? Once all the snazzy presentations are over, do they buy this ‘third way’ story? Robeco’s Marco Büchler was delighted to convince one investor that factor investing does indeed offer a third way between active and passive investing.

“Robeco has certainly established a very strong reputation in the field of quantitative investing; we have become a key player in the ‘Champions League’,” says Büchler , who heads Robeco’s distribution team in Switzerland. “We now have a number of major international clients that have selected us to manage their factor investing portfolios.”

MARCO BÜCHLER HEAD OF ROBECO’S DISTRIBUTION TEAM IN SWITZERLAND

“Robeco has certainly established a very strong reputation in the field of quantitative investing; we have become a key player in the ‘Champions League’,” says Büchler , who specializes in factor investing from RobecoSAM’s offices in Switzerland. “We now have a number of major international clients that have selected us to manage their factor investing portfolios or that have opted for our low-volatility strategy, Conservative Equities and Conservative Credits.”

Büchler says that although Robeco pioneered quantitative investing in the early 1990s, it remained hard to effectively communicate the potential offered by factor investing until 2010. This was because in 2008 and 2009, many clients were still preoccupied with limiting the damage caused by the credit crisis. But that gradually started to change the year after. “At that point, we had already built up a live track record with the Conservative Equities strategy that we launched in 2006,” he says. “This involves harvesting the factor premium of low-volatility stocks that show aboveaverage risk-corrected returns over the long term. Various major parties started working with us at that time. And since then the interest has just continued to grow. Private banks are increasingly opting for passive investments in combination with active asset managers who are able to comfortably cover their costs in the form of higher returns.

That includes multi-factor solutions, which represent ‘a third way of investing’. This approach is slightly closer to passive investing, because the tracking error is lower, and the costs are also slightly lower than those of ‘normal’ active funds.”

In September 2015, one such private bank took the plunge and decided to dedicate a strategic part of its portfolio to factor investing. The bank divided its equity portfolio into three different parts. One part is made up of passive solutions; another part comprises factor investing; and the last part is a satellite solution, which can incorporate mostly high conviction tilts to regions and/or themes. The bank received many different proposals for managing the different parts, and Robeco’s Multi-Factor Equities fund was eventually selected for the factor part.

“The fact that we had involved the bank in our research into factor investing for many years was the decisive element,” explains Büchler . “We had a short live track record in multi-factor investing, but the strategy was based on extensive portfolio simulation, going back 30 years. And, of course, at that point we did have plenty of experience with individual factor strategies, including Conservative Equities, and the bank also had had extensive access to the inner workings of our company. They knew how we built on our expertise in factor investing to develop new ideas.”

“For example, we have helped the bank concerned to explain the philosophy and methodology of factor investing in a straightforward way to advisers, fund selectors and portfolio managers.”

Another private bank, which started a factor-investing portfolio in late 2014, has since asked Robeco to manage the low volatility and momentum equity factors. These two single factor strategies can be used as building blocks to construct a multi-factor portfolio. “We are of course delighted that they eventually chose us to manage such strategic portfolio positions, but we like to go a step further than just effectively managing the assets entrusted to us,” explains Büchler . “For example, we have helped the bank concerned to explain the philosophy and methodology of factor investing in a straightforward way to advisers, fund selectors and portfolio managers. This includes jointly organizing internal workshops and meetings where presentations are given to clients. We’re really pleased with how all this has progressed.”

Conclusion: Join the revolution!

In conclusion, investors really are putting the proverbial money where the mouth is in factor investing, and assets under management are set to increase in the years to come. 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. Part of the reason is that for all its supposed complexity, it basically boils down to making it simple.

“We can see there are clear benefits in diversifying across factors, and implementing multiple factors simultaneously does not have to be difficult,” says Houweling.

“Investors can themselves combine single factor strategies, but the easiest option is to choose a fund that offers diversified exposure: one that can incorporate an efficient implementation, including monitoring exposure and rebalancing. And mandates can always be specifically tailored to investor needs and preferences.”

“We see an increasing number of investors actually implementing factor investing in one way or another.

Given the vast amount of evidence in favor of it and the fact that it is getting more and more embraced by the industry, we strongly believe factor investing is here to stay,” adds Huij. “Working directly with any interested investors is key,” says Shaw. “Robeco focuses very consciously on sharing knowledge – client papers, seminars, answering questions, presentations to advisors and end clients – a strategy that has more than paid off,” he says. “Satisfied clients have now also become very loyal partners who develop tailored investment solutions together with us.”

Join the revolution! www.robeco.ch/en

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