Factor investing – or tilted indices as the strategy used to be known – is becoming increasingly popular with retail investors, largely due to the growth in ETFs. But it is not as simple as it seems. Factor strategies may seem cheap, but there are risks attached.
Institutional investors have understood the world of ‘factors’ for years. They know that investing in a particular style, such as value or quality, will have its ups and downs in the short-medium term. They also know that by using what’s now known as ‘smart beta’ strategies, you can blend those styles and avoid the potential long-run downside when a style is out of fashion. And, given that the quant managers who run them charge a lot less than their active colleagues, the long-term after-fee returns tend to be better. But, value, for instance, has underperformed the Australian share market for the past eight years. That’s a long time.
On a regular visit to Australia last week, New York-based Andrew Ang, a managing director of BlackRock and head of the firm’s factor-based strategy group, said that an increasingly important aspect of factor investing was including active management processes in the strategies. The fastest-growth ETFs ibn Australia, for instance, are those which are actively managed.
But in Andrew Ang’s quant-based world this is controversial. He justifies his position this way: The late Jack Bogle, founder of Vanguard and the hero of the market-cap index funds, created ready access to markets for ordinary people, to “democratise access”. But Ang’s mission is to democratise access to various styles of investing.
Here’s a party trick if you are cornered with a quant investor. You ask him or her ‘how many factors are there?’ There is no answer to the question and the person will normally struggle to respond, which may be helpful if the party is particularly dull. Ang will say about “half a dozen” of a macro nature and another half a dozen of a style nature. Rob Arnott of Research Affiliates fame (see separate report this edition) reckons it’s just over 200. Some others say it’s about 18,000. And others, including this reporter, think it is infinite. We could come up with a new factor over a cup of coffee.
Ang says there are four stages that most institutional investors go through as they embark on the factor journey. They are:
- Choosing a factor style, such as value, growth or quality and rank this alongside a market-cap index
- Going beyond that looking to blend strategies
- Using other insights from the portfolio construction process, and
- “Factor Nirvana”, where the factor strategies are implemented “in the right way”.
Ang says that it’s a bit like creating a balanced diet. It’s not only about public equities. Private equity and real estate can also be added to the mix.
In terms of the definition of a “factor”, which has become an industry talking point of late, Ang says there are also four criteria: the strategy has to have an economic rationale; it needs a long-term information time series; it needs differentiated returns patterns, and; it has to be able to be implemented at scale.