Factor investing outpacing traditional market-cap indexing

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Factor investing continues to expand and mature, based on broadly favourable outcomes and investor satisfaction, but the real test will come, perhaps soon, when the many relatively recent adopters take their factor strategies through a market downturn, according to a new study.

This may prove an inflexion point in which, should factor continue to meet or exceed expectations, it jumps from the early adopters into the mainstream, according to the latest study on factor investing by global manager Invesco.

The third annual survey of factor investing, ‘Invesco Global Factor Investing Study 2018’ involved interviews with 300 institutional and wholesale investors around the world. It shows the trend to factor investing is continuing and provides various insights into investor behaviour.

For instance, rather than take a new allocation to a factor strategy from an existing active strategy, in a bid to decrease potential risk, investors are more likely to fund it from their traditional passive allocations, despite usually incurring slightly higher fees. The study predicts that factor investing will continue to encroach on market-cap passive’s relative share of the total pie.

The 96-page study, overseen by Georg Elsaesser, senior portfolio manager for Invesco Quantitative Strategies, says investor intentions are strongly net positive. With a combination of in-line or better-than-expected experiences, plus fee benefits in many cases, the majority of current factor investors intend to add to their allocations on a three-year view. This intention is slightly stronger amongst institutional investors where around two thirds intend to increase factor allocations.

“Very few investors intend to decrease allocations;” the study says. “Even those amongst the small segment of disappointed investors are more likely to maintain their current allocations rather than reduce them. Combined with the probability of increased adoption amongst today’s non-factor users, the three-year outlook for factor investing remains very positive.”

Looking at the drivers of increasing adoption, improvement in net performance is seen as the most important by some distance, with risk less prominent, especially compared to the initial motivations of taking up factor investing. Cost benefits are also important for smart beta product allocators in particular.

The expected sourcing for increased factor allocations differs significantly across each dimension. For product types, investors intending to increase smart beta allocations have broad sourcing intentions across active, passive, new cashflows and mixtures.
For investors expecting to increase active quant allocations, the predominant funding sources are seen as active allocations and new cashflow.

For more sophisticated investors, active allocations are in most cases less common as the intended funding source. For sophisticated institutional investors looking to increase smart beta allocations, they are more likely to draw on active allocations than passive allocations, although sophisticated wholesale investors are still slightly more likely to draw on passive.

Overall, there is a trend where increasing factor user sophistication results in increasing factor allocations, and where those allocations are funded from within the portfolio rather than new cashflow, the funding source shifts from active to passive allocations.

“As the overall factor user cohort gains experience and becomes more sophisticated, that implies that this trend will become more embedded over the longer term,” the study says. “If so, this will further drive up average factor allocations relative to average passive allocations, cementing the place of factor investing in portfolios, with the potential to ultimately challenge the current place of traditional market-cap passive allocations in investor portfolios.”

In the absence of a major market event to provide a crisis test, a key risk seen continues to be crowding out. Yet here, too, concerns are abating. The level of concern about crowding has dropped significantly in two years. It is particularly low amongst European investors, and slightly higher amongst APAC institutions and North American investors, but overall this is one of the lower ranked ongoing concerns of factor investors.

Rather, the drivers which would cause factor investors to rethink their commitment are a reversal of the performance and risk benefits which most have seen so far, or an adverse effect on costs – in other words if the factor investing ceased to deliver on its value proposition.

Helpfully, the study also addresses the issue of confusion about the main terms often used by investors and consultants to describe the same thing. The authors say that “factor” is the preferred investor term for the overall philosophy of systematic investing strategies. Other common terms such as “smart beta” and “active quant” are seen as product-related terms which are part of the overall factor hierarchy. “Investors see industry standardisation of factor terminology as a desirable development which will help its spread to new adopters,” the authors say. They do not mention “risk premia” investing as another alternative term.

In a confused category terminology landscape, ‘factor’ is the preferred investor term for the overall philosophy of systematic investing strategies. Other common terms such as ‘smart beta’ and ‘active quant’ are seen as product-related terms which are part of the overall factor hierarchy. Investors see industry standardisation of factor terminology as a desirable development which will help its spread to new adopters.

– G.B.

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