Factor-based investing gains in Asia, but questions remain

Initial moves by Asia-based institutional investors into smart-beta equity strategies have focused on specific factors, but money managers say current and prospective clients are beginning to consider a broader range of factors and how to combine them.

Most industry research remains focused on single factors — low volatility, value, quality or momentum — but the question of “how you combine those over time ... is where investors are going now,” said Kevin Hardy, a managing director and head of BlackRock Inc.'s Singapore office, in an Aug. 24 interview.

A central question in that discussion is whether to use single-factor portfolios as building blocks, or instead pursue a bottom-up approach, employing a rules-based mechanism to select stocks offering the best mix of factors sought by a client.

While it's still early days, a number of analysts say the evidence points to the bottom-up approach being more efficient and effective.

If a client wants exposure to value and momentum, then pairing a portfolio of value stocks that do well, mediocre and poorly from a momentum perspective and a portfolio of momentum stocks that do well, mediocre and poorly on a value perspective is less efficient than selecting stocks on the basis of both factors, said Seth Weingram, a senior vice president and investment strategist with Boston-based quant firm Acadian Asset Management LLC.

“Single-factor implementations have their role (but) multifactor is where you get the juice,” added Churchill G. Franklin, Acadian's CEO, in an e-mail. Optimizing factor exposures simultaneously rather than building from single-factor pieces is key to avoiding dilution effects and “unintentional exposures,” he said.

Mr. Weingram added the bulk of Acadian's $69.7 billion under management is in multifactor strategies.

Harindra de Silva, president of Analytic Investors LLC, Los Angeles, said a paper he co-authored that's set to appear in the Financial Analysts Journal later this year reaches the same conclusion — showing a combination of four separate factor portfolios for low volatility, size, value and momentum adding considerably less value over and above the returns of a market-cap-weighted index, than a portfolio of stocks selected on the basis of offering exposures to all four factors.

A paper from Greenwich, Conn.-based AQR Capital Management LLC likewise concluded that integrating factors yields better results than simply mixing them, improving “excess returns by about 1% per year” while increasing information ratios by 40%.

The end result of that bottom-up approach is a more efficient portfolio, with more persistent exposure to the factors a client wants and better performance, at least historically, said Chia Chin Ping, Hong Kong-based head of Asia-Pacific research with MSCI Inc.

Minimum-volatility strategies have offered some of the strongest outperformance numbers in relation to market-cap-weighted indexes over the past decade. For example, the returns for the MSCI All-Country World index, minimum volatility (USD), exceeded the MSCI ACWI index by more than 7 percentage points over the first seven months of 2016; by more than 10 points for the 12 months through July 31; by more than 4 points for the three-year period; and more than 3 points for the five- and 10-year periods.

Skeptics, however, point to an almost equally long period of underperformance for value following the global financial crisis as a reason not to take the superiority of factor-based investing for granted.

One potential drawback, noted MSCI's Mr. Chia, is that a portfolio of stocks optimized for exposure to three or four factors is likely to be “much more concentrated,” limiting the strategy's capacity. On that score, “if you want to put tens of billions of dollars” in a multifactor portfolio, using a mix of single-factor strategies would offer much more capacity, he said.

If those views point to a fast-forming consensus on the charms of bottom-up multifactor exposures, the asset owner community has yet to sign on in a big way.

For the moment, the bulk of big asset owners in Asia with factor-based allocations are still investing in an individual factor strategy, while a far smaller number have more than one single-factor strategy, said BlackRock's Mr. Hardy. At most, there's probably a handful that have hired a manager to build stock-by-stock multifactor portfolios, he said.

On Aug. 22, First State Super, a Sydney-based fund with A$57 billion ($42.8 billion) in superannuation assets and another A$24 billion in retirement assets, joined that small if growing fraternity, awarding an A$1.6 billion multifactor emerging markets equity mandate to Neuberger Berman LLC.

Wai Lee, New York-based head of quantitative investments for Neuberger Berman, said in an e-mail that his team is taking a bottom-up approach to selecting emerging markets stocks with exposure to the factors — primarily quality and value — that First State Super wants.

Still, in an Aug. 31 interview, Richard Dell, the London-based head of Mercer Investment Consulting's global equity boutique, predicted the more complex, less transparent nature of bottom-up multifactor offerings, together with the higher fees they command, could prove a hurdle for institutional investors drawn to single-factor strategies because of their “ease of understanding” and extremely competitive fees.

A case in point: on the same day as First State Super's announcement, the NZ$30 billion ($21.8 billion) New Zealand Superannuation Fund announced it had hired Northern Trust Asset Management to manage NZ Super's first factor-based allocations of NZ$300 million each to low volatility and value.

In an e-mail, Roland Winn, manager-investment analysis with the Auckland-based sovereign wealth fund, cited “transparency and control” as reasons for NZ Super's decision to favor two separate factor allocations over a bottom-up multifactor portfolio.

One cost of that bottom-up approach is becoming “a lot more dependent on your manager's models,” making it harder to understand what the strategy is delivering, said Mr. Winn. Higher potential returns, meanwhile, would have to be weighed against higher management fees, he said, adding that New Zealand Super opted for “greater visibility.”

“We may revisit this over time as the strategy broadens, but there will always be a hurdle for giving up transparency and simplicity,” said Mr. Winn.

Analysts see other factors promoting broader asset owner interest in multifactor exposures. The price, in short-term tracking error, that those allocating to single factors like low volatility have had to pay in return for long-term outperformance is one reason client conversations are trending “more and more” to multifactor approaches, said MSCI's Mr. Chia.

Any of those persistent market factors would have outperformed market-cap-weighted indexes long term, but a multifactor approach should help offset the cyclicality of specific factors, which can test the staying power of most institutional boards, he said.

In its June paper, meanwhile, AQR noted that, ironically, the more efficient factor exposure offered by bottom-up, multifactor portfolios could leave them underperforming mixes of single-factor portfolios when the factors in question are experiencing cyclical downturns.