What’s Driving Institutional Investors Towards Factor Investing?

Factor investing isn’t a new tactic. In fact, institutional investors have been employing factor research for decades. Many are already executing this investment strategy, whether they realize it or not. We believe, as institutional investors realize lower returns for most asset classes, their need for alpha will have many of them gravitating toward factor investing.

With this not-so-new tactic, investors can move away from active management fees—which are quite high—towards much lower-cost factor – indexed strategies. New technology and a broad range of analytical tools have made it easier to analyze a wide range of factors. This helps investors understand how factors work within their portfolios.

Factor investing goes beyond smart beta strategies by measuring both performance sources and existing portfolio risks. This enables a hybrid solution of both active and passive management and also allows for ETFs that specifically concentrate on both of these attributes, that we believe will result in a better target asset allocation.

We believe that Factor investing gives most investors a competitive edge within the portfolios they construct. It also means better liquidity and lower fees—attributes that become more important in low-return environments. Unsurprisingly, a recent survey showed that institutional investors plan to increase their factor allocations from 12% to 18% over the next five years1.

Ultimately, investors want to maximize their risk-adjusted returns. After the 2008 financial crisis, which revealed how various underlying factors could negatively impact unrelated assets, investors in our opinion, want full transparency while getting the most out of the equity asset class.

Is factor investing the “holy grail” of investing strategies? It’s still hard to say. But this tactic has the potential to deliver a return that’s much less cyclical than the returns on most passive strategies. Factor investing uses a systematic method to maximize the return of available assets at a much lower cost and over a longer period. It’s clear why institutional investors are giving this approach more attention.

This kind of factor-based strategy isn’t only being applied to equity investments. Companies around the world are developing transparent solutions that are rule-based for other asset classes, including fixed-income. We believe this shows that factor-based investments and strategies seem to be a good business decision all around.

In the past, active managers charged an arm and a leg for factor investing. The need to process research and calculations manually made data analysis far too time-consuming. Things are different now, as new innovative apps and tools have made data analysis cheaper and more accessible. These tools also make for better informed, smarter investors. The market for analytical tools is very competitive, with new apps and SAAS software sprouting up in digital marketplaces daily.

Some investors theorize that the more factor investment strategies are used, the harder it will be to get a return. The factor-based investment market is approaching the $500 billion mark, leaving many worried about market saturation. However, the money in this pool is not ‘new money’ as much as it is ‘existing money’ that’s been repurposed more systematically2This means market saturation might not be an issue for a while.

There are various methods of incorporating factor investing in a portfolio. A common factor strategy utilized today involves allocating as much as 30% or more of core equity allocation—and investing it on factors such as momentum, value, and quality. As more data and analysis have become available on the market, investing has grown more strategic. This allows for a more sophisticated approach where the impact of factor-based investing is noticeable across whole portfolios while still maintaining transparency for the investor.

Some things worth noticing in factor investing include trading, capacity, how to handle liquidity, and how performance should be measured. Advisors and institutional investors have the goal of building portfolios that meet a specific need for their clients or themselves. Whether they’re looking for aggressive or passive, low volatility or high returns, they should consider factor investing at some point when constructing a portfolio. So, what would that look like?

There are two different types of factor-based investments: Single-factor investments and multi-factor investments. Investors should consider which of these strategies makes the most sense for them to use based on several variables.

Single-factor Investments
Single-factor investments track, follow, or aim for a single factor such as momentum, whereas multi-factor approaches combine several factors.

Single-factor investments are more straightforward than multi-factor investments. Since they are much easier to create and to operate, the investor can continually change their investments/positions to achieve the desired exposure. Unfortunately, this also allows for investments to underperform if the wrong factor is chosen or the timing is wrong. Thus, single-factor investments are better utilized by long-term investors or those with firm convictions about a specific factor.

Multi-factor Investments
With multi-factor investments, investors are offered a broader range of benefits. This makes multi-factor investments more attractive but through a more complicated process. If an investor is considering multi-factor strategies, they should consider each factor they plan to invest in and construct that factor individually.

The decision to use simple patterns or more complex ones is ultimately up to the investor. While a simple pattern makes it easier to explain benchmark differences, a more complex portfolio may achieve better results. The potential choices and outcomes in factor investing suggest that spending time on selecting the right factors and creating the most efficient portfolio constructions can significantly impact the overall performance of an investor’s factor investment(s).

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1 2019 ESG Survey, Callan Institute

2 Jeff Benjamin, Growth of Factor Based Investing