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Blog Posts — February 12, 2018

Factor Investing: Q&A on Flows, Outlook

Last year, net inflows into so-called smart beta exchange-traded funds (ETFs) and products (ETPs) worldwide rose 33.2% from $54 billion in 2016 to $72 billion, according to ETFGI.

Money going into vehicles tracking indices weighted in other way than market capitalization is testament to the popularity of factor strategies. Through risk factors, investors search for drivers of returns premia in the market that have shown to generate outperformance in the long term. An increase in the number of passive investment vehicles that offer such strategies in a systematic way has opened up the world of factor investing to a much larger audience.

We spoke to Jan-Carl Plagge, head of applied research at STOXX Ltd., to ask him why factor-based passive strategies are proving so popular, and what the outlook for the sector is going forward.

Jan, why have passive factor strategies become so popular?

Factor investing has been around for quite a while now, and passive products tracking these strategies provide investors with a possibility to approach them in a transparent and inexpensive way. Factor indices come with some valuable tools: foremost is that they are rules-based, so there is a systematic methodology that is also replicated in the research implemented in stock selection.

For many institutional and retail investors, factor-based investing is the middle ground between traditional active and traditional passive, and that is a very interesting proposition that I think is being reflected in inflows.

What type of strategies are you seeing the most interest in?

The two big areas of interest are risk-reduction strategies and return-enhancement strategies. In the first group you find low-volatility and minimum-variance approaches, which have become a common presence in passive portfolios since the global financial crisis. There has been no slowdown in demand for these strategies in recent years. Investors appreciate the defensive profile of low-vol strategies in the face of falling markets, but also like the fact that these strategies tend to outperform in the long run.

In the other group, single- and multi-factor strategies have become very popular over the last few years as channels to extract specific market premia. Factor indices provide investors with a great tool to express an active view on style, coupled with the efficiency of a systematic approach that is transparent and low-cost. The iSTOXX® Europe Factor index family and the iSTOXX® USA Factor indices that we developed together with Alpha Centauri cover six popular style factors: size, quality, carry, value, momentum and low risk. And really the possibilities are endless when combining factors.

The suite also includes the iSTOXX® Europe Multi-Factor and the iSTOXX® USA Multi-Factor indices, which aim at simultaneously capturing premia from the aggregate of factors rather than from just one source of risk alone. Lastly, the iSTOXX® Europe Single Factor and Multi-Factor Market Neutral indices give investors pure exposure to the factor dimension as they hold at the same time a short position in STOXX® Europe 600 Index futures, therefore excluding the market’s systemic risk.

Our Europe Factor indices are investable through futures on Eurex.

As is the case with most strategies, diversification is key when considering a factor-based portfolio approach. In our in-house studies, the multi-factor strategy returned significant premia over any single factor strategy over a period of 12 years that we analyzed.

What are some of the positive characteristics that can be attributed to factor strategies?

Our analysis shows that all long-only iSTOXX Europe Single Factor Indices provided significant excess returns relative to their benchmark during a sample period going over a decade What may be interesting to investors, additionally, is that correlations between the market-neutral factor indices, i.e. the risk premia, and the benchmark STOXX® Europe 600 index were very low and even negative over the study period, meaning they can also serve as a great source of diversification.

You mentioned low cost. How important is that as a driver for flows into factor-based index products?

Our experience is that lower fees can be a defining variable when comparing active versus passive strategies.

But what investors also focus on is the methodology of any index strategy: Is it simple to understand? Are the reporting and rulebook transparent enough? Does it consider issues such as member liquidity? Is deviation from a benchmark contemplated? When you add all those advantages up and compare it to an active approach, the result goes much farther than just a cost advantage.

Is there a risk that factor indices become too popular, ‘crowding’ some strategies?

As with all asset classes, any equity strategy will be susceptible to and defined by its risk premium. Any factor return can be explained as a reward for taking on risk. If too many investors flock to a market sector, or style, or country, then the risk premia will decrease and its valuation rise, and will ultimately lead investors to realign positions. There is an economic rationale behind this, and no threat of ‘crowding’ in factor indices more than there is for the broader equity market or for market-cap indices.

Indices, like single stocks, report their aggregated valuation, something investors can watch to determine if a style has become expensive relative to its history or to other strategies. When comparing the valuations of factors with one another, in this context, it is important to point out that valuations of factor indices may deviate quite significantly from one another. Some factors tend to be more expensive (for example, quality) while others such as value are, by definition, less expensive. The observation that quality is more expensive than value at any given point in time, therefore, is not an indication that quality may face a correction in the near-term future. Investors should also look at the valuation of factors over a long time.

Will the growth trajectory of factor-based passive products continue?

Factor-based passive products are not an entirely new phenomenon, but it is only in recent years that the offer has expanded in full force. I personally think this is a trend that will grow. As the market of index investing continues its growth path, it is to be expected that we’ll see inflows into products that deepen investors’ possibilities to extract what was initially considered alpha.

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