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The Evolution of Factors in Investment Strategies

A recent survey by Blackrock indicates a majority of institutional investors plan to increase their use of factor-based strategies over the next three years.

In our view, this trend is an evolution and simplification of the investment process -- from a world where investors have individual but overlapping processes (strategies, axioms, rules of thumb, etc.), to one in which the components of the decision making process are broken out, defined, transparent, measurable, and made directly actionable.

Active managers are faced with time and resource constraints. They often depend on a set of screens to narrow their investment focus, metrics to objectively compare investments, and more artful due diligence elements such as channel checks, management interviews, competitive analysis, intuition, luck, and “Je Ne Sais Quoi”. Each puts their best effort into their process, and charges fees for their active management.

A majority of institutional investors plan to increase their use of factor-based strategies.
 Some aspects of individual managers’ strategies are often common and shared widely. Strategies like screening stocks by Price to Earnings (P/E), Return on Equity (ROE), momentum, and accruals can be automated and separated from an individual analyst’s workload. This leaves the manager more time and energy to focus their human skills on the process. This is much like the evolution of the auto industry from craftsmen that built each car by hand to Henry Ford’s separation of operations, standardization, and the Model T assembly line.

Individual Strategies with Overlapping Factors *  
*for illustrative purposes only

Individual Strategies with Overlapping Factors

By disaggregating the process this way, managers can also focus on measuring and improving the different components of the process. Analytics like S&P Global Market Intelligence’s Alpha Factor Library enable performance tracking of common strategies, and answer questions like “What portion of investment returns were attributable to simply screening on P/E, ROE, Momentum, or Accruals?”, “How did those screens perform by sector and by country?”, and “How did they perform over longer history vs. more recently?”. Answers to these questions may help managers make informed decisions when choosing factors for investment strategies.

Factors as a Separate Part of Process*  
*for illustrative purposes only 

Factors as a Separate Part of Process

“Smart Beta” or factor ETFs are one way in which investors may be directly exposed to strategies that use these factors, often at a lower cost than active management. Alternatively, active managers can build upon the factors with the component of their skills that cannot be automated. We still believe in the value of active analysis, and due diligence of stocks – but with the evolution of factor investing and smart beta alternatives, the active manager now has a clearer benchmark against which to showcase their skills.

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Sep 16, 2015
Quantamental
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