Factor challenges: preparing for implementation
How should I prepare for the implementation of a factor-based strategy? Factor investing has become increasingly popular in recent years. But how to implement it in practice still remains a puzzle for many newcomers. Properly planning and timing implementation is oftentimes seen as a major challenge.
• Few academic studies provide concrete guidelines for factor investing • Investors should first assess, and then choose, structure and monitor factors
• Different implementation vehicles can lead to very different outcomes
Even though the empirical foundations of the existence of factor premiums were laid over 40 years ago and are now deeply rooted in the academic literature, so far the number of studies focusing on the practical aspects of implementing factor based strategies has remained relatively small. In particular, fundamental issues such as the very basic questions investors should ask themselves when considering different sorts of strategies, or the steps to follow in order to integrate factor investing, have seldom been discussed in the research.
Without doubt, several relatively recent works have started to fill this gap. For example, in an article published in 2016 in the Journal of Portfolio Management, Kees Koedijk, Alfred Slager, and Philip Stork provided pension fund trustees interested in factor-based strategies with concrete guidelines, as well as a step-by-step checklist. The authors also discussed a number of case studies, in order to illustrate the widely ranging situations in which this kind of investment approach is worth considering. But this paper is more the exception to the rule, as most studies on factor investing do not discuss practical implementation issues.
Interestingly, while academics may have somewhat overlooked these issues in their research, asset owners clearly perceive them to be a major challenge. A FTSE Russell survey carried out in 2016 suggested that planning and timing implementation is one of the top 10 concerns of investors looking at factor based strategies.
Assess, choose, structure, monitor
The obvious starting point is to make sure one understands the theory behind factor investing. It is important to comprehend the major empirical findings on which it is based, before forming investment beliefs and goals. In the process, clients should make explicit the kinds of risks they are comfortable with and the role factor investing should play in achieving their objectives, in accordance with their own investment policy.
‘Client needs in terms of factor exposures or flexibility with regard to a reference index can differ greatly’
This is important since needs and priorities, in terms of factor exposures or flexibility with regard to a reference index, for example, can differ greatly from one asset owner to another. For example, while some investors may be willing to fully embrace factor investing, others may only be looking to reduce downside risk in their overall portfolio. And while some may already be considering risk from an absolute perspective, others may not be ready to abandon their benchmarked investment approach.
Then, investors should assess their existing factor exposures and, from there, determine the desired mix. In so doing, they will eventually be able to tackle any unintended biases, for example, or to tilt portfolios towards a given factor that is of strategic interest. At the same time, it can also be useful to consider replacing the discretionary active managers whose performance is largely dependent on factor premiums, and replacing them with cheaper factor-based solutions.
The following step should be determining how best to implement factor investing in the portfolio management process. In their study, Kees Koedijk, Alfred Slager, and Philip Stork, identified three main ways, depending on how rigorously an asset owner wishes to implement factor investing.
First, they mention the ‘risk due diligence’ approach, which ‘only’ involves checking and monitoring exposures to different factors, and embedding these considerations in the investment process. Then, they discuss the ‘factor tilts’ approach, which refers to actively tweaking a portfolio’s exposure towards a certain factor or group of factors, within an existing the asset allocation framework. Lastly, they describe the ‘factor optimization’ approach, whereby the portfolio is constructed solely with the use of factors.
Finally, because the factor exposures of a portfolio inevitably shift over time, regular assessment will be required and corrective action will likely also be needed to return to the desired level of factor exposure. The frequency of such assessments will have to be determined before implementation has begun.
Different needs, different solutions
For both of these last two approaches, investors will have access to a wide array of products available in the market, from basic exchange traded funds (ETFs) replicating on publicly available indices to sophisticated actively-managed funds. Broadly speaking, asset owners can choose between either the replication of publicly available smart beta indices, a rules-based tailor-made index designed in-house by an asset manager, or a purely asset manager-led approach. In terms of design, the former is similar to classic passive strategies, while the latter can be considered a variation on a traditional active strategy.
As explained in previous articles of this series dedicated to the major challenges associated with factor investing, clients should, however, be aware that different types of products may lead to very different outcomes. ETFs based on generic smart beta indices may appear at first sight to be the cheaper and more straightforward option, but they also involve serious pitfalls and may not be optimal from a performance perspective. Meanwhile, the investment process of excessively sophisticated active strategies may be too opaque and, as a result, the associated portfolios and transactions may prove difficult to explain.