With the increasing popularity of factor-based investing it is important to understand potential pitfalls, according to Raewyn Williams, the director, research and after-tax solutions, for Parametric Australia. It’s not as simple as it seems.
In a recent client note Williams says super funds are becoming increasingly attracted to factor-based investing because it offers transparency and control over risk exposure and can also reduce fee pressures.
“However the challenge is in constructing equity portfolios to effectively seek specific underlying factor risk exposures. It is not just about knowing what you want, but it also requires insights about how to gain exposure to a particular factor, or combination of factors, and understanding the potential pitfalls of a factor-based investing approach,” the note says.
“Factor-based investing can seem similar to pure market-cap passive investing because of its rules-based approach. But, in reality, it is quite different from a pure passive approach because there are so many questions to ask.
“When working with super funds to design and implement their desired factor exposures, we ask specific questions about how they define the factor, whether they are targeting a single factor or a factor combination, and how they expect the factor to perform through different parts of the market cycle.
“Super funds need to clarify whether they’ll be using the factor strategy strategically or opportunistically, and what they believe the appropriate performance benchmark is.
“And, importantly, we ask how tax efficient they believe the factor strategy will be…”
Williams says that the questioning process helps investors move from the first stage of competence, as referred to in psychological literature – “where you don’t know what you don’t know” – to the stage where you “know what you don’t know”.
As an example, Parametric recently collaborated with a super fund to help determine the best way to target a specified “pure factor” exposure and eliminate unintended stock, sector, country and factor bets in the fund’s international equity portfolio.
The manager used optimisation tools to analyse different risks across different market conditions. It found that, in this instance, controlling for stock-specific exposures and unintended factor bets were key. Other aspects, such as regional neutrality, country and sector concentrations, were less important.
Williams says: “We identified a favorable blend of portfolio construction specifications to obtain the desired factor exposure within the fund’s tracking error constraints and help to control for the other concerns and expectations the fund had. The fund was able to pinpoint the outcomes that mattered and the specific levers and settings to be used to target these outcomes.”
* Greg Bright is publisher of Investor Strategy News (Australia)