Factor investingGain exposure towards systematic equity factors
Our wide range of Exchange Traded Funds (ETFs) offer access to single equity factor indices developed by leading financial index provider MSCI. This unique range of Factor ETFs aims to equip investors with tools to tilt their portfolio strategies towards factors within tactical or strategic asset allocation models.
The phenomenon of factor investing (also known as 'smart beta' investing or 'alternative beta' investing) has received a lot of attention amongst investors and the broad media. Factor investing has been researched continuously since the 1970s, with academic researchers identifying that value, quality, low volatility and yield all tend to outperform the market portfolio in the long term. Different explanations can be found in literature, ranging from behavioural economics to corporate finance to statistical modelling.
Many studies document that indeed investment strategies based on these factors would all have beaten the World index. In essence, factors can be thought of as a consistent characteristic that is critical in explaining the risk and return profile with a group of related securities. The four-decade run of outperformance by the MSCI factor indices1 proves that substantial and persistent factor premia have been present. But it also shows that the factor-based strategies have steadily been corrected over time (i.e. periods of relative overperformance interchange with periods of relative underperformance), indicating that there is no free lunch.
The different behaviours of each of the following factors should lead investors to consider a wider range of factor investment opportunities in their portfolios. The successful implementation of factor investing requires detailed understanding of what it is about- the upside as well as downside risks.
Figure 1 shows the positioning of factor investing highlighting its presence between market beta and pure alpha. Factor investing is actually about getting exposure to rules-based, transparent and high-capacity strategies, where the selected stocks meet certain eligibility criteria, and are weighted proportionally to the factor exposure, e.g. the value stocks receive more weight with lower valuation ratios. These strategies typically under-represent and tilt away from the market, so investors may benefit from diversification, but they also face other factor-related risks.
A market capitalization weighted index (market beta) reflects the available opportunity set of equity investments. If an investor wants to understand how equity markets perform, the best measurement is the market cap weighted benchmark. The market beta portfolio is also a natural benchmark for any other strategies, including factor investing or pure alpha investments.
The very DNA of factor investing is to provide tilts away from market capitalization weighted benchmarks, by following a standardized, disciplined, transparent and rules-based process of stock selection.
Figure 2 shows the actual multi-step process required to construct a factor-exposed index. This process defines a rigorous portfolio construction, with stocks that best qualify for the factor exposure.
The four main factor exposures demanded by investors focus on
These strategies have very intuitive appeal on the one hand, and they are well researched and backed by empirical studies in the financial literature on the other hand. For example, the total shareholder yield strategy aims to select these companies that return capital - either through dividend payments or buyback programs - to their shareholder. To achieve this objective, this factor strategy will screen in the entire universe stocks that consistently deliver shareholder value. It will then rank the companies in view of the shareholder yield, select top companies meeting certain threshold, and finally the strategy will overweight (or tilt towards) the most valuable stocks generating shareholder value.
Figure 2: Indexation of Factor Indices
Source: MSCI. UBS Asset Management. For illustrative purpose only.
Addition of alternative beta to the portfolio requires better understanding of the factor exposures and their properties. Each factor strategy has its own objective which determines its application in the portfolio.
The value factor looks for relatively undervalued stocks as measured by fundamental company metrics (e.g. Price-to-Book Ratio, Price-to-Earnings Ratio or Price-to-Sales Ratio etc.). Numerous studies have demonstrated that value stocks tend to outperform their peers in the long-term. The outperformance can be rationalised by the fact that value investors take on additional risk by investing in cheap stocks, and expect higher return for risk-taking. Value stocks are mostly looked for when financial markets experience off-equilibrium valuations.
The low volatility factor selects companies whose stock market price variation is low and hence help to reduce portfolio risk. Low volatility stocks tend to outperform high volatility stocks; this is known as 'the low volatility anomaly', as it contradicts the conventional financial wisdom of risk-return trade-off. However, low volatility stocks prove to be in high demand when uncertainty around financial markets increases, leading to their more robust market behaviour.
The quality factor provides exposure to a portfolio of boring stocks. Quality companies are characterized by durable business models which should remain profitable, regardless of the business cycle. In addition, quality stocks tend to have modest variability in earnings, e.g. utility companies. High quality stocks, as selected by accounting criteria (e.g. profit margin, earnings growth, return on equity, debt-to-equity), tend to outperform low quality stocks in the long-term. They are particularly in demand when financial markets are expected to experience turbulence.
The yield strategies are designed to capture the performance of companies that return above-average cash to shareholders either by paying dividends or through share buybacks. The excess cash can either be reinvested to finance further company growth, or it can be partially shared with the shareholders. Many yield-focused strategies select companies that have balanced pay-out ratios and have proven to generate persistent shareholder value in the long-term.
Every factor strategy represents exposure to systematic sources of risk expressed through the factor load(2).
Figure 3 shows the historical factor loads of the four factor indices. This chart is a standard way to evaluate the factor load of specific strategies3. In this framework, every investor must first assess the role of factor investing and what it aims to achieve through the investment. For example, the quality companies have a relative negative tilt towards financial leverage defined as debt-to-equity ratio. This implies that quality companies use relatively low level of debt to finance increased operations, investments and business activities. While highly leveraged companies may have potential to generate higher earnings in expansive economy, then the cost of debt financing might turn excessively high with the economic downturn.
Figure 3: Factor Load of Factor Indices
Source: Barra. UBS Asset Management. For illustrative purpose only
For many years, factor-based investment strategies have not been widely accessible and rather exclusive to a small group of investors. The recent increase of interest and demand has led many of the factor strategies to become 'indexed' and widely recognized and well established index providers (e.g. FTSE, MSCI, STOXX etc.) have engineered replicable factor indices.
With the rise of passive investments (e.g. Exchange Traded Funds), the access to value, volatility, quality and yield has never been easier than today, and there are many good reasons to consider them as an addition to a portfolio (see summary in Figure 4.) Traditionally, portfolio allocation has been defined as a core-satellite approach, where core exposure was covered by market beta portfolios and satellite investments were covered by alpha investments. With the emergence of factor indices, the new core-factor-satellite investment approach develops, where the factor beta investments can be accessed through investible factor indices. Implementation of factor investing is generally governed by the investor's constraints (risk budgets, investment horizon, costs etc.) and can vary from a dynamic allocation (higher return and higher risk), a defensive allocation (moderate return and lower risk), or a balanced allocation (something in between).
The core-factor-satellite framework offers a number of ways to implement factor allocations in a portfolio. The implementations can focus on addition of one preferred factor, or combining two or more factors in addition to market beta, as shown in Figure 5. The factor exposures differ in their properties and their behaviour over different business cycle phases. For example, value and yield are more pro-cyclical, whilst low volatility and quality are more counter-cyclical. Most importantly, regarding diversification, combining factors historically could have helped offset the downside risk of the market portfolio, or could have help achieving higher participation in the upside market. Multi-factor strategies have historically demonstrated four key benefits: diversification, transparency, cost-efficiency and flexibility4. In general, the implementation of factor investing depends on the investor's objectives and constraints.