Investors overwhelmingly prefer to implement factor strategies through exchange-traded products such as ETFs, according to a study on factor investing by Invesco.

Georg Elsaesser, Senior Portfolio Manager, Quantitative Strategies at Invesco.

The study – based on interviews with over 300 wholesale and institutional investors across 21 countries, collectively responsible for over $19 trillion in assets – found that more than half (51%) of factor investors preferred ETFs as their vehicle of choice, followed, at a distance, by segregated mandates (23%) and other types of pooled vehicles (6%).

European factor investors are even more avid users of ETFs and similar products (55%), as are North American users of smart beta strategies (59%).

Asia Pacific investors, on the other hand, currently lean towards segregated mandates (63%), reflecting the larger sizes of their portfolios and factor allocations and lack of locally listed exchange-traded products.

Barriers to factor investing falling

The study also found that the barriers to factor investing are falling rapidly as factor understanding and competency continues to improve. The most significant barrier, internal capability, has fallen notably over the past two years, dropping 1.8 points when rated on a scale of one to ten.

In addition, barriers such as belief in factor theory, executive support from internal stakeholders, and crowding have all declined over this period. For seasoned factor investors introducing additional strategies, barriers are 10-15% lower.

As confidence in factor investing grows, the asset management industry is accelerating changes to how it captures the benefits of factor investing, with half (50%) of institutional and a third (33%) of retail investors hiring talent to manage factor allocations more effectively.

Third pillar

Georg Elsaesser, Senior Portfolio Manager, Quantitative Strategies at Invesco, commented, “Factor investing’s progress is forcing a structural change within the industry, creating a true third pillar in the investment world, distinct from traditional active and market cap-weighted passive. Investors – both wholesale and institutional – see factor investing as a distinct competency requiring specific rather than generalist expertise from elsewhere in the internal team.”

Continued growth

The prediction that factor allocations will continue to rise over the coming years, a conclusion of the 2017 report, continues to hold true. Around 60% of investors overall (64% of institutional and 56% of wholesale investors) plan on increasing their factor allocations by 2021.

While the sentiment of global investors is to increase their factor allocations over the coming three years, this is even more the case for Asia Pacific factor investors. Over three quarters (77%) of respondents intend to increase factor allocations, in comparison to 57% in Europe and 54% in North America.

The key driver for further increases in allocations by investors is, by some distance, better net performance, followed by cost-effectiveness and two dimensions of risk reduction.

Types of factor strategies used

Style factors continue to be the most widely used set of factors and, within this, value remains the most popular (used by 78% of factor investors), followed by low volatility (62%), size (53%), and momentum (53%).

There are some significant regional variations. In Europe, factor investors make less use of value than the global average and more use of high yield. Asia Pacific investors favour value and quality, while North American investors prefer value and size.

Funding for factor strategies

With the increased demand for factor strategies, funding is coming from a mix of new cash flow, and existing active and passive allocations.

The study reveals a nuanced picture, with high variation between strategy type. For new smart beta type allocations, transfers from passive allocations are almost as important a source of funding as those from active allocations.

European factor investors have a similar funding profile with 45% of smart beta allocations being drawn from active allocations, 40% from passive allocations, and 15% from new cash flow. For active quant type allocations, new cash flow is a significant secondary source of funding after drawing from active allocations.

Once investors commence their factor journey, it is uncommon for them to stop with a single strategy. On average, wholesale and institutional investors have gone on to implement between two and four factor strategies.

In the institutional space, Asia Pacific investors have the highest number of factor strategies deployed (3.5 on average), although European investors consider themselves to be generally more advanced in their use of factor strategies.

In Europe, factor strategies are also prevalent amongst wholesale investors with an average of 3.4 smart beta strategies deployed, although North American usage is boosted by widespread availability of smart beta ETFs (4.5 strategies deployed on average).

Positive experience

Despite many factor investors being relatively recent adopters, the great majority report a positive experience. Over half (53%) of wholesale investors found smart beta allocations have exceeded expectations versus passive products, with a further 40% noting performance has been in line with expectations.

When comparing performance relative to their active products, a quarter (25%) of institutional investors stated smart beta allocations have outperformed expectations. Additionally, a third (33%) of institutional investors have found this form of factor investing has surpassed expectations compared to traditional active.

The factor experience has been even more positive for those who consider themselves to be more sophisticated investors, exceeding expectations for over two fifths (41%) of respondents.

ESG

A relatively new theme emerging from this year’s study is the use of factor allocations to address portfolio ESG requirements. Almost half (47%) of institutional investors believe factor investing can address ESG objectives, and over a third (38%) of wholesale investors echo this belief.

The use of factor strategies to address ESG requirements is even more common amongst sophisticated institutional investors, as 60% see potential ESG applications for factor strategies.

Elsaesser said, “To see significant levels of support for more advanced applications such as ESG is encouraging for longer factor investing demand. Importantly, this belief resonates with both institutional and wholesale investors.”

He concluded, “Since conducting our first study three years ago, we have seen the factor trend grow rapidly. Although some investors already have lengthy experience with factor strategies, many users are still relatively recent adopters. Across the industry, as the user cohort grows in experience and sophistication, we can expect a consolidation of these trends. Factor allocations will continue to rise relative to other allocations, consolidating its evolution from a complex and experimental strategy to a third strategic pillar to stand alongside familiar active and passive styles of management.”