Factor-based challenges

There are so many elements to consider when building factor-based solutions it can be overwhelming. We’ve highlighted two case studies of investors tackling these challenges.

The growing investor appetite for factor-based index solutions is well documented. Gaining factor exposure can help deliver specific objectives such as higher returns, lower risk or greater diversification in a cost-efficient way. However, meeting these goals requires thoughtful understanding of strategy selection and portfolio construction.

The number of factor-based products is continually increasing and it is becoming harder for investors to distinguish between them and select the most appropriate ones for their aims. We examine two case studies of pension schemes which sought factor exposure, examining the issues they faced and how a portfolio can be structured to take advantage of the opportunities that factor-based investing can present.

The dangers of a bolt-on approach

One of the key problems of factor-based products is that there can be significant performance differences between strategies with similar names. Multi-factor investing is the latest area of innovation where a number of different factors are combined together in order to diversify the risk of any single factor underperforming. Commonly, different factor-based indices that are constructed independently are chosen, with an equal weight assigned to each.

David Barron is Head of Index Equity and Factor Based Investing. He focuses on research and strategy in addition to overseeing the team responsible for index equity implementation. This was the approach adopted by a UK local government pension scheme. The investor had invested into a value factor index a number of years ago. Once more comfortable with the premise of factor-based investing, the investor expanded to include quality and low volatility factor indices. Eventually they chose to equally weight each in order to create their own multi-factor strategy.

However, problems with this approach emerged as the value index was highly diversified and carried low factor exposure while the other two were more concentrated, delivering much higher factor exposure. Moreover, given cross-factor interactions present (i.e. a factor index having exposure to the other two factors), the combined effect resulted in a negative exposure to the value factor at a portfolio level – an outcome the investor was certainly not expecting. Further to this, since the strategy had not been rebalanced for over two years the portfolio had shifted away from its equal weight position (to have even less value factor exposure).