Factor investing takes hold in Asia as new asset management tool

Asian institutional investors increased allocations to factor investing in 2017

Feb 2, 2018 | Stephen Quance

Factor investing has gained increasing recognition from investors for its systematic, data-driven approach to delivering specific outcomes. At its core, utilizing intellectual advances to seek exposure to a group of assets that share similar factors – such as value, quality and momentum – represents a breakthrough in the fundamental elements of investing and will take a permanent place in asset management.  Common goals include increasing returns, controlling risk or a combination of the two.

There are already signs of the growing adoption of this approach. The Invesco Global Factor Investing Study 2017 showed that institutional investors in Asia increased their factor allocations from 7% of AUM in 2016 to 10% this year. Meanwhile, factor strategies also increased in Europe and North America, accounting for 19% of AUM in each region.

To the extent that factor exposures help explain security returns, all investors already have some degree of exposure to one or more factors. Unless they employ an explicit factor-based approach; however, their portfolios might demonstrate a very different risk and return profile from what was intended. Implementing a dedicated factor strategy, on the other hand, enables direct control over factor exposures that academic research has shown help improve our understanding of risk and return.

Understanding through intuition

The origins of factor investing date back more than 50 years, but there is still sometimes confusion about what it actually means. A helpful way to understand the factor approach is to think about it in terms of its uses. From this perspective, factors fit into one of two categories, diagnostic and investment, based on what portfolio objectives a manager is trying to achieve.

Examining a portfolio using a factor lens is often an eye-opening experience because investors can review their investment strategy from a unique vantage point and pinpoint the degree to which each component contributes to overall performance. Factors like unemployment and inflation, for instance, enable investors to assess how exposed their portfolios are to different stages of the economic cycle, similar to a doctor collecting information to diagnose a patient’s condition. This depth of insight can help investors take forward-looking action and gain greater precision in determining which levers to pull.

Investment factors are those that can be managed using securities, providing the building blocks for a portfolio or strategy. These include factors like low volatility, momentum and value. To use these factors, an investor must first define how to measure for the desired characteristic and then screen a universe of securities against that to determine which constituents fit best on a relative basis.

A flexible and scalable option

Factor investing is customizable and can exist as either a standalone portfolio or a complementary subset of an existing one. Depending on investor needs, they can implement an active or a passive factor approach, based on a single-factor or a multi-factor strategy. Regardless of the implementation method, a factor-based portfolio potentially offers access to more stable returns and pursuit of specific outcomes.

It is also flexible and enables investors to make portfolio changes relatively easily as best practices evolve. Desired factor exposures are achievable as long as the eligible universe is fairly diversified. If an investor identifies a new way to define value, for example, he or she can simply cross-check the universe of publicly traded securities against that new measurement and draw from the ones that rank highest. A bottom-up manager, on the other hand, might need to devote an extended period of time re-visiting with companies to identify which ones best fit a new standard.

This flexibility is particularly helpful when considering environmental, social and governance (ESG) integration. For investors that decide to exclude certain categories like firearms or gaming from the portfolio, they must identify suitable alternatives in a timely manner. This is an easier transition for investors using a factor-based approach because they can simply redefine the acceptable investment universe and use it as the starting point.

Scalability is another strength when it comes to managing assets since factor exposures are defined across a broad and diversified set of securities rather than just a select handful. This makes it possible to manage very large amounts of assets in an expedient way that is not constrained by first having to cultivate personal relationships with companies or develop expertise with their unique lines of business.

Increasing usage

Factor investing is a new pillar of investing, alongside traditional alpha sources and market cap weighted indexing. This is good for end-investors because it provides them with a new tool. A factor approach could be appealing for investors who want to increase returns, but do not want the specific risk that comes from alpha managers. It may also be suitable for those who want to manage downside risk but are still aiming to pursue excess return over passive strategies. The “best strategy” depends on what the investor would like to accomplish.

Going forward, rigorous research and technology advances will continue to enhance the capabilities of factor investing. Best practices have already advanced significantly compared to what was possible just a few years ago to the point where current models are shown to generate improved outcomes compared to previous iterations. It’s not right for every dollar in every situation, but there are an increasing number of situations in Asia where investors are starting to take note of factor investing as a compelling option.

 

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