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Factor Investing – A Wide Highway Ahead?

Foto: ChristianeFe. photography / Pexels CC0 License
By Andrew Ang

As investors continue to add factor-based strategies to their portfolios, industry watchers have wondered: are factor strategies getting too popular?

I hate waiting in traffic. I don’t like the stops and starts, the feeling of crawling along, and just all that crowding. As any driver knows, it’s not just the total number of cars that matter, but also the size of the road itself: the same amount of traffic on a freeway versus a winding single-lane road makes all the difference between a smooth journey and a traffic jam.

More than $18 billion flowed into U.S.-listed smart beta ETFs in the first half of 2017, following the $43 billion invested in 2016.1 These numbers sound impressive, so not surprisingly, some investors have wondered if factor strategies have become crowded, eroding their potential gains. But in the broader context: are factor strategies a highway or a backcountry road? Have factor strategies reached their capacity? Let’s start by citing some important facts and figures.

How much is invested in factor strategies today?

Currently, assets in factor strategies are simply dwarfed by the assets invested in traditional vehicles, such as passive and active funds.  As one example, consider smart beta funds that invest in S&P 500 Index constituents. The S&P 500 Index represented $19.2 trillion in market value as of December 31, 2016. Of the $8.7 trillion in assets indexed or benchmarked to the S&P 500, actively managed mutual funds accounted for $5.7 trillion. In comparison, U.S.-listed, U.S. equity smart beta ETFs represented approximately $224 billion, or less than 1.2% of the market capitalization of the S&P 500 Index. The current amount invested in smart beta funds is tiny!

Unlike some strategies prone to capacity constraints such as micro-cap stocks or active strategies that traffic in thinly traded names, factor strategies have generally tended to invest in more liquid securities trading in deep markets. Factor funds may be more able to invest new fund flows without unduly affecting the prices of securities, giving them the potential to accommodate large flows.

Trillions of dollars in active funds already follow factors

While the amount directly invested in smart beta strategies is miniscule, many institutions are already factor investors, even though they might not explicitly allocate to smart beta or factor strategies. Our research decomposed active mutual fund returns into three components: factors, time-varying components and security selection. Of the trillions of dollars in U.S. active mutual funds, we believe that the first component, static factor exposures, may represent well over $2 trillion of assets under management.  In other words, money is already following these factor strategies; what is changing is the way investors are accessing those factors.

Measuring the capacity of factor strategies

There are several ways to estimate the capacity of factor-based strategies, including asset ownership, capital flows and transaction costs. Let’s consider transaction cost estimates, which may not provide definitive measures of capacity, but are certainly informative measures of real-world trading experienced by investors.

Each incremental investment into a factor-based strategy incurs an additional transaction cost. There is a breakeven point where all investors’ new flows are eaten up by transaction costs, offsetting the historical smart beta premiums. How far away are we from that breakeven point for assets under management, which indicates that there is no additional capacity?

To address the capacity question, we used Blackrock’s proprietary transaction cost model, which covers tens of thousands of securities, including more than 50,000 equities. The model is used by BlackRock investment teams on a daily basis and incorporates turnover, volume, market-wide and stock-specific risk, commissions, taxes and spreads and other inputs. The model is used for trading across all of our portfolios — not just the securities within smart beta strategies.

What do transaction costs tell us about the potential capacity of factor strategies?

With a five-day trading horizon, which is appropriate for large trades, value, momentum, quality, size and minimum volatility factors each show capacity potential in the hundreds of billions. Some factors, like minimum volatility, may have capacity well over $1 trillion. For comparison, the iShares Edge MSCI Min Vol USA ETF had $13.6 billion in assets as of June 30, 2017. The momentum factor has the highest turnover and volatility relative to the other style factors, and accordingly, should have the smallest capacity. Yet, even for momentum, our estimate of capacity exceeds $320 billion. As of June 30, 2017, the iShares Edge MSCI USA Momentum Factor ETF had assets of $3.1 billion. For the majority of the factors, the breakeven point for transaction costs indicates a capacity that far outstrips the assets currently invested in those style factors.

What about crowding and valuation?

Crowding, or a crowded trade, presents a risk of investors who hold large and similar positions exiting those positions simultaneously. Crowding may manifest in short-term trends and high, short-term valuations. These are important concerns, but they are different from long-term capacity considerations.

All assets undergo periods of upward or downward trends and high or low valuations. A skillful investor might be able to use relative strength and valuation metrics to tilt factor positions gradually over time. Other signals useful in a factor-tilting framework might include dispersion and the economic regime. Read my recent post on factor tilting for more on how tilts may help improve returns and check the outlook for our latest views on factor over- and underweights.

Ample room on the road

So, what about the naysayers claiming that factor strategies are at capacity? We’ve done the research and it suggests there is large capacity potential in smart beta and factor strategies. We believe capacity could be at least hundreds of billions and, in many cases, trillions of dollars of assets — more than 100 or 1000 times more than what is invested in factor strategies today — for capacity to be reached. Factor strategies appear to have a wide highway ahead.

Column by BlackRock written by Andrew Ang

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