Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 182

Why is factor investing a ‘thing’?

There’s a lot of hype around a trend called ‘factor investing’ which (as part of broader ‘smart beta’ thinking) has been called “the fastest growing segment of the investment management industry” (for example, this article). But what is factor investing, why is it important and why do many believe it is more than just a fad? This is written from the perspective of a large superannuation fund equity investor.

Starting with the basics

Let’s begin with the simple notions of ‘beta’ and ‘alpha’ in an equity portfolio. Broadly, beta (denoted by the Greek letter ß) captures the amount by which an equity portfolio moves with the market. So, a passive strategy which tracks the broad market (for example, S&P/ASX 200 or MSCI World) will have a beta of 1. On the other hand, alpha (denoted by the Greek letter a) captures the amount of portfolio movement not related to the market. Superannuation funds often appoint active managers to generate ‘positive alpha’; that is, returns above a pure market return. Of course, alpha can be negative, meaning the portfolio has underperformed the market. The typical way of thinking about equity portfolios is to examine the beta and alpha components which together explain the entirety of a portfolio’s performance.

The alpha/beta distinction gives a superannuation fund investor a useful choice between adopting a fairly cheap passive approach to deliver equity beta returns or adding the costs of active management to the portfolio to (hopefully) deliver extra performance through alpha.

Enter factor investing. The insight at the heart of the factor trend is that a lot of alpha can actually be explained by some common factor risks that exist across stocks. The academic literature dates back to 1976 and the most well-accepted equity factors are Value, Quality, Size, Momentum, Dividend Yield and Low Volatility. Value and Low Volatility seem to be of particular interest to large superannuation funds at present. These investors are also exploring variations like factor combinations, timing factors and tax-managed factor approaches. There are key differences in the behaviour of factor risks between the Australian and global equity markets, which investors need to understand.

Challenging the traditional alpha/beta model

Factor investing challenges the traditional alpha/beta investment paradigm because it suggests that much of what has been labelled alpha is actually returns from simple factor bets (a type of beta). A factor-based equity approach can be constructed using straightforward ‘passive-like’ rules, offering transparency and control. They can be offered in a separate account or pooled fund form, including ETFs. These investment options offer superannuation funds the opportunity to outperform the market without the costs associated with active management. Avoiding the ‘black box’ of many active management approaches is also an attraction. Factor investing is a ‘thing’ because funds realise they have three choices – alpha/factor beta/traditional beta – not just two.

Our most recent factor research identified one of the common traps funds fall into; inadvertently introducing other risks into an equity portfolio while trying to construct a pure factor exposure. We also noted, perhaps counter-intuitively, that factor investing does not ring a ‘death knell’ for active equity managers who have been important components of the equity puzzle for many funds to date. Rather, factor investing provides an opportunity for active managers to clearly differentiate themselves from mere ‘factor providers’ and to negotiate generous risk budgets with their clients to deliver true alpha based on their research and unique insights.

For superannuation funds (and other investors) who embrace the factor trend, their job is twofold: to implement a well-constructed equity portfolio that reflects their factor convictions (and, as far as possible, nothing else); and to reposition their active manager partners (and internal management teams) to harvest alpha as a true complement and enhancement to the fund’s factor bets.

 

Raewyn Williams is Managing Director of Research at Parametric, a US-based investment advisor. Parametric is exempt from the requirement to hold an Australian Financial Services Licence under the Corporations Act 2001 (Cth) in respect of the provision of financial services to wholesale clients as defined in the Act and is regulated by the SEC under US laws, which may differ from Australian laws. This information is intended for wholesale use only and not for retail clients, as defined in the Act. Parametric is not a licensed tax agent or advisor in Australia and this does not represent tax advice. Additional information is available at www.parametricportfolio.com/au.

 


 

Leave a Comment:

banner

Most viewed in recent weeks

Where Baby Boomer wealth will end up

By 2028, all Baby Boomers will be eligible for retirement and the Baby Boomer bubble will have all but deflated. Where will this generation's money end up, and what are the implications for the wealth management industry?

Are term deposits attractive right now?

If you’re like me, you may have put money into term deposits over the past year and it’s time to decide whether to roll them over or look elsewhere. Here are the pros and cons of cash versus other assets right now.

Uncomfortable truths: The real cost of living in retirement

How useful are the retirement savings and spending targets put out by various groups such as ASFA? Not very, and it's reducing the ability of ordinary retirees to fully understand their retirement income options.

How retiree spending plummets as we age

There's been little debate on how spending changes as people progress through retirement. Yet, it's a critical issue as it can have a significant impact on the level of savings required at the point of retirement.

Is Australia ready for its population growth over the next decade?

Australia will have 3.7 million more people in a decade's time, though the growth won't be evenly distributed. Over 85s will see the fastest growth, while the number of younger people will barely rise. 

20 US stocks to buy and hold forever

Recently, I compiled a list of ASX stocks that you could buy and hold forever. Here’s a follow-up list of US stocks that you could own indefinitely, including well-known names like Microsoft, as well as lesser-known gems.

Latest Updates

Property

Financial pathways to buying a home require planning

In the six months of my battle with brain cancer, one part of financial markets has fascinated me, and it’s probably not what you think. What's led the pages of my reading is real estate, especially residential.

Superannuation

Meg on SMSFs: $3 million super tax coming whether we’re ready or not

A Senate Committee reported back last week with a majority recommendation to pass the $3 million super tax unaltered. It seems that the tax is coming, and this is what those affected should be doing now to prepare for it.

Economy

Household spending falls as higher costs bite

Shoppers are cutting back spending at supermarkets, gyms, and bakeries to cope with soaring insurance and education costs as household spending continues to slump. Renters especially are feeling the pinch.

Shares

Who gets the gold stars this bank reporting season?

The recent bank reporting season saw all the major banks report solid results, large share buybacks, and very low bad debts. Here's a look at the main themes from the results, and the winners and losers.

Shares

Small caps v large caps: Don’t be penny wise but pound foolish

What is the catalyst for smalls caps to start outperforming their larger counterparts? Cheap relative valuation is bullish though it isn't a catalyst, so what else could drive a long-awaited turnaround?

Financial planning

Estate planning made simple, Part II

'Putting your affairs in order' is a term that is commonly used when people are approaching the end of their life. It is not as easy as it sounds, though it should not overwhelming, or consume all of your spare time.

Financial planning

Where Baby Boomer wealth will end up

By 2028, all Baby Boomers will be eligible for retirement and the Baby Boomer bubble will have all but deflated. Where will this generation's money end up, and what are the implications for the wealth management industry?

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.