Factors matter.
A lot, according to Bill Muysken, Mercer global chief investment officer alternatives.
Muysken told the Mercer NZ annual conference in Wellington last week that the quantitative investment strategies that emerged out of academia in the 1970s have now hit the big-time.
“There are now US$2 trillion invested in ETF [exchange-traded fund] factor strategies – a sixty-fold increase over the last decade,” he said. “That’s what all the fuss is about.”
But the factor proliferation has brought with it complexity and confusion for investors while the flood of money into the sector potentially renders many of the strategies ineffective.
Alternatively known as ‘smart beta’, factor investing has assumed many forms including a common association with passive strategies, which Muysken said is mis-labeling.
“Factor strategies are not passive,” he said. “We think of them as another type of hedge fund.”
Indeed, some have suggested that the typically much-cheaper factor products could completely usurp the traditional hedge fund sector, which has a reputation for high-cost, obscurity and arrogance.
Muysken said factor investing could replace some hedge funds but there were many other alternative investment strategies that will never fit easily into the quant boxes of smart beta enthusiasts.
He said the increasing popularity of factor strategies has been boosted by a number of features besides cost such as transparency, ease of diversification, an absolute return focus, “intuitive” investment ideas, and returns that have – for the most part – delivered as promised.
Arguably, though, the fee discount has been the most powerful growth driver of the smart beta trend.
“But it’s important for investors to ask themselves some sobering questions,” Muysken said. “If the fees were 0.5 per cent higher would you still invest in it? Are you willing to accept lower net of fee returns just because it’s cheap?”
Furthermore, he said for all the factor positives, investors also have to weigh up the rapidly-changing risks in the sector such as rising transaction costs (that can obliterate returns), more complexity as well as increasingly ‘crowded trades’ as investors pile into popular strategies – pushing up expenses and possibly killing whatever alpha the strategy offered in the first place.
“And it’s very difficult to identify true factor investing talent,” Muysken said.
The increasing number of ‘factors’ entering the lexicon on top of the original few such as value, growth, momentum and size, compounds the problem, he said.
According to Muysken, as well as the standard-issue variants many smart beta merchants tout proprietary factors, which pop in and out of existence like virtual particles from quant-built black-box algorithms.
“Investors in factor strategies have to ask how confident are they that they will get the promised outcomes,” he said. “Factor back-tests always look good and they always come with good explanations. But are the underlying factors real or a mirage?
“Some factors have stopped working – in some cases just because of the weight of money investing in them.”
Usually, too, different factors tend to under- or out-perform at different times, which explains why a growing number of institutional investors (including the NZ Superannuation Fund) are looking at multi-factor exposures.
But once-in-a-while all factors fail in a convergence known as a ‘quantquake’ or ‘quantmare’. A quantquake famously struck in 2007 just prior to the global financial crisis; the market experienced a similar event in 2018.
Muysken said factor strategies have recovered somewhat since last year’s shock but Mercer has slightly reduced its exposure to smart beta.
“Every hedge fund strategy will have a bad year from time to time,” he said. “We still think factor investing has a role in well-diversified portfolios – but you have to calibrate how much you need.”
Regardless, he said investors should consider the role of alternatives in “future-proof portfolios”, particularly at the end of decade-long bull-runs in both equities and bonds.
Many long-term investors should be able to tolerate up to 50 per cent of their portfolios in alternatives such as hedge funds, private equity and real estate, he said. Mercer portfolios typically allocate between 10 to 30 per cent in alternatives.
The Australian-born Muysken moved from Sydney to London in 1997 to take up the global head of research role for Mercer before assuming his current alternative position in 2010.
Interestingly, his factor presentation would have been material news to a large chunk of the Mercer NZ delegates: in a live online survey, about 20 per cent of the Wellington audience said they had never heard of factors while a further 30 per cent admitted to only a little knowledge of the smart beta matter.