Advisers need to understand equity factor investing and how it can be used for short-term tactical or long-term strategic investing.
Globally, smart beta funds attracted $24bn (£18.7bn) of new investment in the first quarter of this year, representing a 2,000 per cent increase compared with the same period in 2016, according to independent data provider ETFGI.
Moreover, ETFGI reported that smart beta funds, focusing on equity factor exposures such as value, quality, low beta and so on, had the strongest inflows of all smart beta in the first quarter.
As usual, the US appears to be leading the way, with institutional investors and advisers starting to use factor investing much more frequently.
Advisers here in Europe also need to at least understand what factor investing is and how they can potentially use it.
First, a quick recap on the fundamentals of factor investing. Traditional asset allocation is done on the basis of diversification across asset class categories and geography.
However, when the financial crisis kicked in during 2007/08, that model of diversification proved unsatisfactory as asset classes that had previously been relatively uncorrelated started to move in sync and all fell at the same time.
This prompted researchers and practitioners to look for a better way to achieve diversification and understand portfolio performance. The result was the identification of a series of fundamental factors that provide a better insight into the risk and reward of groups of securities.
The quality factor, for example, starts from the basis that the application of certain filters to rank companies on metrics such as return-on-equity, debt-to-equity on the balance sheet and earnings variability can produce a ranking of companies based on the quality of their balance sheet.
That weighting in favour of those higher quality companies increases the chances of outperforming the market overall over the long term, with the market performance measured in the traditional way with companies weighted by market capitalisation.
Similarly, a value factor approach would apply a systematic filter to weight companies based on value metrics such as price-to-earnings ratios, among others.
Research has shown that long positions in these factors can produce superior risk-reward outcomes in the long term versus traditional cap-weighted passive approaches, which is one of the reasons why there is now a proliferation of factor indices and associated ETFs tracking them.
Some institutional investors are also creating portfolios starting from the factor approach as a way to gain a truly diversified portfolio.
Factor ETFs are therefore increasingly being used for long-term strategic portfolio construction. However, the more interesting current development is working out how factors can be used tactically in the short term, with some advisers now starting to come up with ways to create semi-active portfolios of factors, and as such providing their clients with a portfolio management service they would struggle to provide for themselves.
One way of doing this is to assess which factors do well at particular times in the business cycle and then overweight to those factors. One big area of current research is developing factor assessment frameworks that break down individual factor performance so informed participants can then adopt a view on which factors are likely to outperform in future.
