Factor-based investing has won many fans in the institutional and adviser worlds in recent years with a compelling mix of high science and low fees.
But a new Mercer study warns that the data-led investment style, also variously known as ‘smart beta’ or ‘systematic’, should be taken with care.
“In our view systematic equity strategies can play an important role in investors’ equity portfolios,” the Mercer report says. “In particular, they are likely to have an increasingly important role for risk-aware, fee-conscious investors. However, as is often the case, the devil is in the details.
“Investors should clearly understand what type of (systematic) approach they are allocating to, and how it fits in with the other strategies held in their equity portfolio.”
The study identifies four smart beta-like styles that sit on the spectrum between cap-weighted index investing and fundamental stock-pickers, ratcheting up in activeness along the scale from factor indexing to active factors to ‘traditional’ then ‘dynamic’ systematic methods.
“Each of these approaches has potential advantages, and none should be viewed as being inherently superior to others,” Mercer says. “For example, dynamic systematic strategies could outperform other strategies for prolonged periods as market environments evolve. However, they may not provide investors with the consistent factor exposure and predictable performance outcomes that they may desire.”
And while systematic strategies might be generally cheaper than full active management, the study says the fee payoff between risk and return can be particular sensitive for factor portfolios.
The report says investors need to “ensure that fees do not consume an unfair proportion of any expected outperformance”.
“While there appears to be a positive (and expected) relationship between fees and risk (tracking error) in systematic equity strategies, there is not necessarily a clear relationship between the fees charged by the managers and the past returns delivered…,” the Mercer study says.
Authored by Mercer researchers, Nicholas Conant, Michael Binz and Gareth Anderson, the paper lays out a few general pros and cons of factor investing.
On the plus side, systematic share portfolios tend to have broad market coverage, significant diversification, predictable performance, few behavioural biases and low costs.
However, the disadvantages include factor ‘decay’, data quality concerns, reliance on “backward-looking signals” and the tendency to struggle during periods of rapid market changes.
Regardless, the Mercer study suggests the smart beta revolution will continue to march on backed by “strong academic support and vastly improved access to financial market data”.