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Factor investing – just a fad? Part I

Release date: 13 Aug 2018 | Eurex Exchange, Eurex Clearing

Factor investing – just a fad? Part I

"On the contrary," says Jan-Carl Plagge, Head of Applied Research at STOXX Ltd. "Factor investing is here to stay." Reason enough to deal with the topic in a series of articles. Part one asks how factor investing has developed, why it is now an integral part of portfolio management, and what contribution Eurex’ Factor Futures are making here.

"The return on these factors is no coincidence," adds Plagge. ”These are no short-term market anomalies, but rather systematic in nature. In this context, it is assumed that “human” behavior plays an important role in the explanation of factor returns. And human behavioral is typically not changed over night.The publication of an abundance of related research demonstrating the existence of such factor returns has led to a veritable surge in interest in factor investing in recent years. Further, the development of innovative indices and the launch of derived products leads to new possibilities to access, extract or combine such factor returns.

Factor investing is not new

Care to take a deep dive?

In STOXX’s Pulse Online publication, you can find an ongoing series of in-depth articles on factor investing, and on a range of individual factors, such as value, size, or momentum.

 
The traditional Capital Asset Pricing Model (CAPM) can be seen as the first factor model. Having influenced portfolio theory since the 1960s, it demonstrated that investment returns were driven by the most basic factor: market risk, or “beta”.

However, over the following decades, researchers extended that first model to account for additional factors. Probably the best-known model is that of Fama and French from 1993. The authors demonstrated that, besides the market factor, the size of a company and its valuation are also important drivers of return. Since then, continued research showed that many other factors, such as momentum, quality and volatility can help explain components of stocks’ returns.

“While factor models have initially been used mainly in order to explain returns, we have seen a constant rise in products that go one step further and actively tilt portfolios towards certain factors in order to exploit those factors and harvest the associated hoped-for returns”, says Plagge.

The use of factor products

With regard to the use cases of factor investing, he differentiates mainly between two cases: one is clearly the return-seeking component: investors in factor products seek returns in excess of those provided by a simple exposure to the market factor. However, we also come to understand that factors – especially when constructed in a market-neutral manner – have an extremely low correlation to the broad market. And this low correlation has a completely different use case just in itself as market-neutral indexes can be added to an existing market exposure in order to diversify and reduce risk.

Looking back at capital flows into factor indexes as they happened over the last years, Plagge states that low volatility and value were among the most popular factors. They saw significant capital inflows mainly in the ETF market. “However,” Plagge adds, “more recently we also see a pick-up in assets flowing into multi-factor indexes as investors do not always have a particular view with regard to the behavior and the performance of a single factor index. Lack of such a view may make it beneficial to just broadly diversify across various factors – various sources of risk. And multi-factor indexes are an ideal underlying for such an exposure.”

Targeted exposure through factor indexes

The possibility of targeting investments by factors wasn’t missed by the indexing business, which started offering products that go beyond traditional market cap-weighted benchmarks. To name an example: in 2016, STOXX developed the iSTOXX® Europe Factor Indexes together with Alpha Centauri. They offer investors a unique and innovative way to capture risk premia. Each index seeks exposure to a targeted factor: value, carry, momentum, size, low risk or quality. The final composition and weights result from an optimization process seeking maximum factor exposure while constraining the influence of systematic risk.

What about derivatives on iSTOXX® Factor Indexes?

To facilitate customers’ access to factor-based strategies, Eurex launched futures on the iSTOXX® Europe Factor Indexes in May 2017. These futures provide an efficient vehicle to access the pure targeted factor return independent from market risk or direction, as investors can hold a factor index future and, at the same time, short futures on the STOXX® Europe 600 Index, all on the same venue.

Zubin Ramdarshan, Eurex’ Head of Product R&D Equity and Index, explains that with these futures investors now possess very efficient instruments that enable them to exploit factors not purely by going long-only but also by employing a long-short strategy. Ramdarshan emphasizes that the indices are designed so that the difference between the factor index and the STOXX® Europe 600 is mainly explained by the exposure to the factor itself, f.ex. by value.

He also notes that the selection of stocks, as well as the determination of corresponding weights, happen simultaneously based on an optimization approach. In order to allow for the extraction of the pure factor premium net of the market, the optimization tries to achieve a beta of one relative to the broad STOXX® Europe 600 benchmark index.

In the second part of this series you will learn more about our Eurex’s Factor Futures.

 

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