Recently there has been a proliferation of investment products focused on factor-based investing, including factor-based index funds, single-factor portfolios and so-called smart beta. Common features include investment theses tied to well-known return anomalies, rules-based portfolio composition and systematic implementation. However, what many investors might not know is that despite a strong marketing push by a number of firms that label this as a “new” and “innovative” investment approach, these types of strategies are in fact not new — they have actually been around for decades. And, if not utilized correctly, they can carry significant risks.
Single-factor approaches can offer utility in many types of situations — for example, as completion funds, to plug a temporary exposure gap, in a transition or as a strategy benchmark. However, many of these new products on the market are highly simplistic, packaged for high volume and ease of implementation. Essentially they are assembly-line products, proliferating at an astonishing rate. In fact, EDHEC's Scientific Beta institute offers more than 4,200 smart beta indexes. This focus on scale means that such products dispense with valuable attributes of more sophisticated factor-based approaches. Investors should be aware of what they could be leaving on the table.
Factor-based investing is the systematic application of predictive ideas to a broad investment universe. Academic research has long demonstrated the existence of persistent anomalies linked to excess return. These are caused by common behavioral errors made by investors and also by the structural constraints in markets and organizations that limit the full implementation of information.
Investors should be attuned to the fact that many of the factor-based products on the market today are designed not around the optimal exposure to an anomaly, but rather the optimal fund structure for mass distribution potential. This puts a premium on qualities like simplicity of investment thesis, process transparency, and the liquidity of holdings. Such products are often accompanied by costs and risks that are difficult for investors to assess.
Factor-based index funds, for example, are often marketed based on an historical simulation showing the performance of the given attribute relative to the market over time. It is rare to see a back test that accurately reflects the cost of maintaining exposure to the anomaly in a real world portfolio. Factors are moving targets, and the group of stocks that provides your exposure today might not have the same characteristics a month from now. A manager thus has a choice — either to chase the factor rigorously while piling up transaction costs, or to go more slowly and accept a constant lag in factor exposure.