Index Investing

The Rise of Factor Investing – is it just monkey business?

The Rise of Factor Investing – is it just monkey business?

According to a recent BlackRock survey, nearly two-thirds of institutional investors have increased their use of factors – the broad “drivers” of risk and return - in the last few years. But like any other investment process, factor investing strategies must be selected – and deployed – intelligently. The factors selected should be robust and persistent, and implemented efficiently at reasonable cost.

Below we have selected ten of the best papers from around the world, to help investors understand the key issues. Many more can be found on the Savvy Investor site.


Is Smart Beta just Monkey Business? (EDHEC-Risk Institute, 2015)
The “Monkey portfolio” proposition is that smart beta strategies can be deployed naively, with the assurance that all such strategies will add value. EDHEC's research suggests otherwise, with many smart beta strategies having exposure to other factors. The authors warn that care is needed to avoid over-extrapolating the implications of a particular test specification of a smart beta strategy into a wider setting.

The Rise of Factor Investing: Adoption by Institutional Investors (BlackRock, 2016)
This survey examines the increasing prominence of factors and factor investing in institutional portfolios. The paper is split into four parts: Introduction; The Factor Landscape; Capital Allocation and Investment Strategies; The Future of Factor Investing. The report is based on a survey of 200 institutional investors from around the world.

Factor-based investing (Vanguard, 2015)
In the factor-based investment framework, factor exposure decisions are integrated into the process of portfolio construction in order to position portfolios actively away from market capitalization weights. This approach has garnered much attention, with some investors curious as to why such an approach endures. In this research paper from Vanguard, Scott Pappas and Joel Dickson address this question, examining the factor framework by investigating applications, practical considerations, and potential benefits.

Multifactor Indexes: The Power of Tilting (FTSE Russell, 2016)
In recent years, institutional investors have become increasingly convinced of the benefits of factor investing, facilitated by the creation of a variety of indices, each focusing on a specific risk factor. The creation of these new indexes has allowed investors to access factor exposure efficiently and at low cost. However, as with any investment strategy, the return from a single-factor index will vary over time, often following different patterns. For instance, the quality risk factor tends to exhibit counter-cyclical performance, whereas the payoff from the value factor normally follows a more cyclical pattern. This paper examines alternative processes for building multifactor indexes, in order to benefit from a diversified exposure to the various source of factor return.

How Can "Smart Beta" Go Horribly Wrong? (Rob Arnott, 2016)
In this paper, Rob Arnott, 'Godfather of Smart Beta', warns investors to recognise that most of the “alpha” produced by smart beta is created by rising valuations. A smart beta crash, he argues, will be the result of valuation norms returning to the mean.

Robustness of Smart Beta Strategies (EDHEC-Risk Institute, 2015)
This EDHEC paper examines how important robustness for smart beta strategies actually is. It explains how "absolute robustness" differs from "relative robustness". The authors describe how the robustness of smart beta performance can be assessed and quantified, describing various approaches, which may be used to improve the robustness of smart beta strategies.

How Smart are 'Smart Beta' ETFs? Relative Performance and Factor Exposure (2015)
In this paper, Denys Glushkov analyzes whether domestic equity smart beta ETFs outperform their benchmarks by tilting towards well-known factors such as momentum, value, size, beta, quality and volatility. He investigates whether factors premiums are harvested more efficiently by Smart Beta funds. 

Quality Investing: High Profitability and Low Investment Factor Indices (EDHEC)
According to asset pricing theory, securities markets are where multiple systematic risk sources are priced. Recently, an increase in the number of factor investing strategies have been seen, which look for exposure to a variety of factors from index providers and asset managers worldwide. A new approach to equity investing, known as smart factor investing, simultaneously addresses the heavy concentration and undesirable factor exposures of cap-weighted assets.

How NOT to Wipe Out with Momentum (Research Affiliates, 2015)
How can the momentum factor be most effectively employed? Does it make sense to seek to capture the momentum risk premium via an index strategy? Chris Brightman argues that it does not. However, the use of the momentum factor in combination with a value factor can enhance the risk/reward tradeoff.

Fact, Fiction, and Value Investing (AQR, 2015)
This paper by AQR Capital Management aims to bring clarity to the concept of "Value Investing". For over two decades now, this idea has been a part of the investment vocabulary. During that time, the diversified systematic “value effect” or “value factor”, in particular, has been extensively studied. The authors explore how the diversified systematic value strategy correlates to its more concentrated application.

Factor Performance in Emerging Markets (Lazard, Apr 2016)
The authors examine emerging market factor returns over a 10-year period, discussing short- and long-term patterns of performance, and comparing the results with data from developed equity markets. The paper also takes an in-depth study of the "value factor". The report is helpful, both for stock pickers and quants, helping to explain the considerations around stock-selection styles in emerging markets, and arguing for a multi-factor approach.

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