Factor fiction: does the asset class work for instos?
In the last three years, factor investing has been letting some of its adherents down.
Value, which has been the most popular factor-based strategy, has underperformed the market, leaving investors to ponder a change of approach.
The strategies take ways to build stock or bond indexes using measurements aside from market capitalisation. The most common factors include size, momentum, low volatility, quality, value and yield. The purpose has been to identify and invest in sets of securities that might do better than the general market across the economic cycle.
That, at least, is the theory.
Investors have been experimenting. Globally, fund managers and asset owners adopted several factor strategies the 12 months up to the end of March, including momentum, low volatility, and quality, outperforming market-cap weighted indices.
And the 12 months through March 2019 saw several factors outperform in global equity markets, including low volatility, momentum and quality. However, some of the most common factor strategies underperformed, particularly value.
Stephen Quance, the Singapore-based global director for factor investing at Invesco, told AsianInvestor that value and size have particularly struggled for the past two years. He argued that investors may have placed too much faith in the concept of factor investing, mistakenly believing that factors always outperform.
Anyone who claims that factor investing is a way to never have a bad three or five period is misinformed
“Anyone who claims that factor investing is a way to never have a bad three or five period is misinformed,” said Quance. “Factor investing is no panacea. If we look historically based on empirical analysis, what we’ve seen in the last few years with some of the most popular factors underperforming is not totally unprecedented.”
TOUGH TIMES
Still, such poor performance is unusual. Value and momentum are often paired in an investor’s multi-factor strategies because they are negatively correlated.
But there have been periods recently, said Quance, where investment indexes created using a value factor have done poorly and at the same time those that use momentum as a factor “have either been weak or slightly negative”.
While the majority of investors (66%) polled in a study by Invesco, published in October, reported their factor investing strategies met or exceeded the performance of their traditional active or market-weighted allocations, Invesco’s fieldwork conducted in the second quarter of 2019 indicates that respondents were more likely to report underperformance than in 2018.
Factor investing has not lost all of its lustre, however. According to Invesco’s research of 241 institutional and wholesale factor investors managing over $25 trillion in assets, most asset owner respondents said they were still inclined to increase their factor allocations.
Aligned with the global trend towards increasing allocation to factor strategies, 55% of Asia Pacific-based respondents to the study said they intend to increase allocations over the next three years, slightly behind the global figure of 59%. These allocations are likely to be sourced primarily from traditional active (78% of Asia Pacific respondents) and market-cap weighted strategies (42%).
“We have seen a drop in the popularity of value, which used to be far and away the number one factor – and an increase in quality, momentum and low volatility. So they are pretty close to balanced at this point. We interpret that as investors wanting to be more diversified across factors,” said Quance.
BLF’S FACTOR FAITH
Taiwan’s Bureau of Labor Funds (BLF) is well known in the region as one of the leading practitioners of factor investing among pension funds. It has so far allocated around 10% of its NT$4.11 trillion ($132 billion) total portfolio to smart beta strategies.
Liu Li-ju, BLF’s deputy director general, told AsianInvestor the internal team has developed its factor strategy by developing indices using single factors and multi-factors that they will rebalance over market cycles.
“We are aware of the issues raised during recent times when certain factors have underperformed,” she said. “Given that this is a relatively new approach, we keep making enhancements in our factor selection and the rebalancing mechanism. We believe this kind of enhancement not only helps us to diversify the factor and market risks, but captures a better return over a full market cycle.”
Quance said BLF’s experience reflects the nature of factor investing and is one of the things investors need to keep in mind.
“Even with factors we think will produce a premium over the cycle, the volatility of the premium is typically two to three times the premium itself. What that means is that unless you can anticipate them, and have a mechanism to do that, long-term investors need to be willing to bear some of the underperformance, because it can last for fairly long periods.”
This article was adapted from a feature on factor investing that originally appeared in AsianInvestor's Winter 2019 magazine.