The Asset Management industry is currently undergoing a period of rapid changes mainly driven by advancements in technology and shifts in investors’ preferences. Changes in market trends have given rise to new opportunities as investors seek to capitalise on new innovations, yet the underperformance of funds point to another challenging year ahead. A study has shown that 86.7% of US active funds have underperformed their benchmark over the 10-year period ending in 2017.
European funds have experienced the same trend, with 85.4% of European equity funds underperforming below their benchmark over the same time frame. This downturn comes at a time when the market is experiencing an increase in the popularity of new investment methodologies, such as factor investing.
What is Factor Investing?
Factor investing is a quantitative style of investing, which involves researching and analysing the characteristics of assets (which are predominantly but not exclusively equities) that has led to them outperforming the market. After these characteristics, known as factors, are identified, they are put through algorithms to show what is the long-term risk profile and returns of an asset. Recommendations on which are the best-performing assets to invest in then can be made.
Factors tend to be grouped into two main categories:
1. Macroeconomic factors (Also known as Diagnostic Factors): Common ones include credit, inflation, and interest rates. Such factors highlight risks and opportunities across asset classes (i.e. a change in these factors lead to a simultaneous rise)
2. Style factors: Popular ones include:
● Momentum: Measures the tendency of winning assets to continue performing well in the near term. As a result, strong assets in this factor benefit from continued positive trends in the markets and a history of strong performance.
● Value: Measures if an asset that has fallen in value over an extended period of time or is cheaply priced is undervalued (i.e. it will outperform peers in the same situation). Assets strong in this factor are expected to perform well compared to pricier peers in the long term, and benefit from cyclical upturns in the market.
● Quality/Profitability: Measures the durability of a company's business model and the sustainability of its competitive advantages. Securities that are strong in this factor belong to companies which have low leverage, stable earnings and high profitability, and are expected to do well even in an economic downturn.
In recent years, factor investing has risen in popularity, as barriers to entry fall and more investors get acquainted with them. Factor investing strategies are increasingly favoured as they are transparent, have low transaction and management costs due to their systematic approach that only relies on quantitative inputs,. Hence, in general, they generate higher returns for firms and are looked upon favourably by investors.
Nevertheless, while strong interest in factor investing a few years back has led to a rise in the returns of stocks and bonds initially, the steady decline of factor performance in 2018 and 2019 has casted some doubt on the future popularity of factor investing.
One of the most popular factors, Momentum, has extended its underperformance in 2018 into this year. Value, another style factor, has also been exhibiting poor performance. Further compound on investors’ woes, is the fact that performance of value and momentum factors are typically negatively correlated - when one outperforms the market, the other usually underperforms. However, in 2018, both factors underperformed, leaving investors wondering if changes in market behaviour is impairing quantitative strategies.
The graphic below depicts how both momentum (represented by a white trend line) and value (represented by a blue trend line) factors have declined in performance measured by the total returns they have generated.
In 2019, Neuberger Berman became the latest big name to close a fund based on factor investing, as other funds suffer from massive losses. The underperformance of funds partially stems from an overcrowded industry, where securities that are commonly picked by multiple factor funds become overvalued. For example, the share of European institutions investing in smart beta has grown steadily from 40% in 2015 to 52% in 2016. Recently, several investors have started to voice their concerns over the popularity and consequently crowdedness of smart beta investments, which may cause securities to become overvalued as more assets are piled into smart beta investments. As the markets realises this, valuations are corrected to their fair, albeit lower values.
On the other hand, some investors view data mining as a huge risk in factor-based investment strategies, as even the most popular factors may turn out to be less effective in generating alpha despite beliefs that basing investment on historical evidence of growth is an ideal strategy This can be attributed to the fact that only 30 years’ worth of data is used for analysis to construct these factors, thus the short history of data may not have been sufficient for the effective construction of factors. Hence, the flawless construction of factors and development of investment strategies cannot be expected from data mining, especially in an unpredictable world today, where market behaviour can easily diverge from the past.