Factor investing as an approach is gathering pace both for active asset managers and increasingly for those in the passive space. Factors give a detailed view regarding how funds behave beyond the headline of returns. This assists investors in the selection and comparison of investment options and it guides asset managers in the construction of investment products. But if you take the debate further, factors also provide a view on the overall quality of the strategy behind fund construction and the consistency of this thinking over time.

Today’s investment manager needs a clear, reliable view across the markets impacting factors, the ability to drill down in portfolios, and tools that identify the comparability of funds relative to each other. Ideally, this should be delivered via one container that also uses the same, common framework for assessing risk and attribution.

What follows is a discussion with Kirsten English, the CEO at Style Research, on how style factors and factor-based investing evolved in 2017, which originally appeared on the firm’s website.

As 2018 draws near, regulation and its potential impacts remain front-of-mind for every global institution. Is the use of factors impacted by any regulatory imperatives?

There isn’t any regulation aimed at the use of factors. The FCA’s asset management report published in June pushed for fee transparency but did not shine a spotlight on the quality of product out there. In a world of Know Your Client (KYC), I would argue we should be more mindful to ‘Know Your Fund’ and what is in it. Transparency into the content of funds would be useful as it shows investors the quality of what they are buying. This is where factors come into play.

How important are factors for passive investing, e.g. for ETFs?

ETFs and smart beta are on the rise – countless statistics spell this out. We know that some of the traditional active asset managers have already gone into the ETF space, and there are likely more to follow. Some ETF’s are built using a factor-based approach. This is part of the philosophy behind their construction as people move away from the cap-weighted ‘vanilla’ ETF offerings.

Has the growth in ETFs created new challenges in factor analytics? Have you seen factors step forward as a core communication tool?

Factors are becoming increasingly important because the first wave of ETF offerings have catered to the ‘mid-market’. As new managers enter the fray with passive and smart beta strategies, they have to differentiate the existing offerings by producing something unique and compelling. Here is where factors can help communicate that difference. Factors can tease out the characteristics of one product versus another. At Style Research all the market participants (asset owner, asset manager, and consultant/advisor) use our platform as the common and independent tool to evaluate products, funds, and funds of funds through a factor lens. They review the same factors, and with that common basis can discuss the same industry standard analysis. We also show how factors behave under different market regimes.

How do factors apply differently to retail and institutional investors?

Institutional investors use factors to evaluate and construct the behaviors of a portfolio. They also check to see if a fund has been consistent to its style of factor investing over a multi-decade period. How does this convert to retail? When an advisor markets a fund to the retail investor, they have to match the client’s needs to their perceived demands. Our categorization shows whether the investor is buying a Value, Growth or Quality fund and so forth, but in a way that retail investors can consume easily. Whilst the institutional investor uses grids of figures in much of their analysis and communication, we draw a ‘Skyline’ visualization which is much more intuitive.

Does the use of factors vary between different regions? Where do you see the opportunity on a geographic basis?

Factors have been used for many years in the US and the UK. But there is substantial growth opportunity elsewhere, particularly in Asia. Asia is not a homogenous unit of course. Australia deploys factor analysis widely. China is at the beginning of its journey.

An interesting topic is applying factors to other asset classes such as fixed income because this approach could be useful in other regions. I also would expect to see more use of factors in constructing specialized ETFs such as for Environmental, Social, and Governance investing.

Could you view ESG itself as a factor?

ESG – we are talking about three different things here, albeit commonly grouped. You have to approach each component of ESG individually and this provides fertile ground for factors. Much of the limitation in ESG currently pertains to the fact that there is not enough quality data, meaning the universe for analysis tends to be skewed towards a Large Cap universe.

What can you get wrong if you are using factors? What are common mistakes that people might make?

One obvious issue is the definition of factors. They can be labeled similarly but constructed differently. Unless you use the same approach across all your investments – as we do at Style Research – you will not get consistent answers.
In the ETF world, the strategies combining multiple factors can be very difficult to understand – largely because there is not an established index to measure them against. So the traditional back-testing methodologies investors use to test robustness may not give enough assurance to the future behavior of an ETF. This makes some of the more esoteric ETFs a riskier proposition.

In addition to what we’ve already discussed, what do you think institutions and their clients should look out for in 2018?

On the growth side, more passive investment products – definitely. Whereas the bulk of funds invested in passives in the US is concentrated in the hands of a few fund managers, the landscape elsewhere will include different players muscling in on the concept but with strong local distribution capability.

I also think we are likely to see more ETFs constructed using big data and artificial intelligence (or rules-based) approaches.

More immediately, however, financial service players in the UK are facing a wall of regulation. Adapting systems and workflow to new regulations costs serious money and eats into profits. We are likely to see industry consolidation accelerate in 2018. The world of institutional asset management is seeing more change than ever before: fee pressure, regulation and a more educated consumer.