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When It Comes to Factor Funds, Bad Design Hurts

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Mike Hunstad is worried that factor investing is getting a bad rap. Hunstad, head of quantitative solutions at Northern Trust Asset Management, says his big concern is when the industry looks at factor strategy underperformance and assumes factors themselves haven’t performed, “when that isn’t the case,” he told ThinkAdvisor.

Instead, factors have performed just fine. “There’s a growing belief that factors in the U.S. have not performed well, when really it’s the strategies that are poorly designed,” he says.

To prove his point, Hunstad authored a new paper, “Danger!! Dilution is Harmful or Fatal to Multi-Factor Performance,” in which he outlines his contention that many multi-factor funds are diluting factor exposure to the detriment of returns.

“Year to date there’s been a lot of volatility in the equity market, and we would expect defensive strategies, for example, low-vol strategies, high-quality strategies, to have outperformed but most have not,” he said. “So the general perception is that low-vol factors have underperformed, but that is not the case.”

A big part of factor strategy return is “predicated on how [the portfolio is] designed … so anytime you implement a factor in a portfolio, you tend to take extra risk that is not necessarily based on that factor exposure.” Hunstad notes that low-vol stocks tend to be concentrated in certain sectors, such as utilities, real estate and consumer staples, all of which have “a lot of idiosyncratic risk associated with them, tend to be larger in size, tend to be expensive, have large-cap bias and a negative value bias,” he says. “So you think you’re getting low vol, but what you’re actually getting is big bets on” those sectors and their risks.

Hunstad points out that in 2018 the low-volatility factor has outperformed the benchmark, but low-vol strategies have underperformed. The reason, he says, is these strategies are overweighted in sectors like utilities and real estate that “have gotten crushed” this year.

Factors Lost That Loving Feeling?

Despite underperformance of sector strategies, factor investing is still hot. According to Hunstad’s paper, as of 2018, $1 trillion in assets were invested in factor-based equity funds — a whopping 30% growth over the previous year. Further, there are thousands of factor products now available.

“I just don’t want investors to shy away from factor investing,” he said. “The most important thing is how the factor is behaving.” He says his firm focuses purely on the factor, and doesn’t dilute the portfolio by taking other sector or style bets. The result is that NTAM’s low-vol strategy has outperformed the benchmark year to date because “we don’t take unintended bets.” He adds that the “key point of factor investing is “efficiency, so you make sure you use active risk to target that pure factor premium, such as low volatility, size, value, etc., but you don’t take unintended bets.”

He said NTAM did a study a couple of years ago looking at 20 of the larger factor-based strategies globally. In the study they assessed what active risk each were taking, and how much of that active risk was being used to target intended factors versus unintended factors, such as sector, region, currency biases, etc. The proportion, he said was “frightening.”

“Only 17% of the risk of these factor-based strategies were being used to target the intended factor,” he said. “That means 83% was unintentional.”

He points out that when you compare factor strategies’ three-year performance, “ostensibly [if] they are all targeting the same factor, same market, same cap spectrum, they should all perform relatively similarly, but they are not. The reason … is they are taking a lot of unintended bets that is influencing behavior, and in fact is dominating the behavior or these strategies.”

As an example, he says, some low vol strategies have upwards of 70% of total weight in utilities and consumer staples, but within “any cap-weighted benchmark” the allocation to either of those two sectors is significantly below 70% — it may be 25%, he says.

Instead, they should be finding low-vol stocks in all sectors,  so they aren’t exposing the portfolio to added, and noncompensated, risk, he says.

“Factor investors are taking a lot of risk that they are not being compensated for,”  he says. “Our thesis is you have to be paid for every point of risk you take, and that’s not happening. Strategies are remarkably inefficient, and investors are getting burned time and time again.”

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