10 insights on rules-based and factor investing · 10 insights on rules-based and factor investing...

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10 Insights on Rules-Based and Factor Investing Facts and Strategies You Can Use in Constructing the Right Portfolio for You

August 2015


10 Insights on Rules-Based and Factor Investing 1

Key Points There are many varieties of rules-based, or “smart beta,” strategies. In this article, we focus on

the equity strategies1 that are currently the most commonly used among institutional investors: fundamental and low volatility.

Rules-based strategy returns are largely driven by exposure to equity risk factors—especially value, small, and low volatility—but also momentum, quality, and several others.

Several factors have produced above-market returns in the past, and it is reasonable to expect that they will do so over sufficiently long periods of time in the future.

Factors will go through long periods of underperformance and require close monitoring.

There are several ways to potentially profit from factor premiums, including traditional active strategies, timing strategies, and rules-based strategies.

Using an “adaptive” skill that adjusts strategy based on complex and changing market conditions is still the best way to exploit market inefficiencies.

We believe asset allocation, not equity strategy, is the most impactful portfolio decision.

The right equity portfolio is dependent on your suitability factors, which include return objectives, tolerance for risk and cost, and oversight resources.

Rules-based strategies are most attractive for investors with cost constraints, aversion to significant active risk from concentrated portfolios, or a desire to reduce market exposure at relatively low cost in the medium or long term through low-volatility investments.

10 Insights on Rules-Based and Factor Investing

Facts and Strategies You Can Use in Constructing the Right Portfolio for You

10. Rules-based investing, or “smart beta,” returns are mostly driven by exposure to risk factors Traditional indexes weight stocks by market capitalization: the market value of outstanding stock. Rules-based portfolio strategies—now often referred to as “smart beta” (we use the terms interchangeably in this paper)—weight stocks by something other than market cap. The simplest non-market cap way of weighting stocks is equal weighting, but that strategy requires holding equal weights in the very smallest stocks, which may be hard to trade. So, most smart beta indexes use something else to weight stocks—i.e., a transparent, rules-based approach. They deviate from traditional cap-weighted indexes by reweighting stocks in a systematic manner based on well-defined factors such as relative price/earnings, relative volatility, momentum, quality, and other risk-based or market segment criteria.

1 While smart beta is a widely used strategy in equities, the general theory and philosophy can be extended to fixed income and

other alternative asset classes. The application of a smart beta approach in asset classes beyond equities is still in its infancy.



Why avoid market capitalization? Critics of market cap weighting point out that if a stock becomes overvalued, it becomes a bigger part of a market cap-weighted index. Investors who hold stocks that become overvalued benefit from the price increase—but if the market eventually fixes its mistake, the investor suffers a loss. A typical smart beta investor would have sold the stock, harvesting the gains as it rose and reducing exposure to its subsequent decline. Likewise, a smart beta investor would buy stocks as they fall, expecting future reversion to fair value. This approach has a lot in common with traditional value investing.

Because smart beta strategies don’t invest as much in the stocks with the biggest market cap, they often tilt toward small cap.

Another flavor, low-volatility strategies, weights stocks based on volatility or market risk—based on the view that low-risk stocks earn better risk-adjusted (or even absolute) returns.

While there are many different types of smart beta strategies, historical evidence has shown that the value and small cap tilts account for much of their returns.2 This evidence includes low-volatility strategies, although current research suggests that additional factors like “betting against beta” (which favors low market risk) explain their returns as well.

Figure 1 shows the long-term value added of several popular smart beta portfolio construction methodologies after accounting for factor exposures—in this case, the value and small cap factors. The gray area represents the boundary of statistical “noise”—as shown, none of the strategies produced an alpha that can be statistically distinguished from zero—supporting the idea that smart beta returns are explained by style.3

Where historical but statistically insignificant alpha exists, it may be attributed to implementation methodology, additional (unexpected) risk factors in the portfolios, or just random noise.

Figure 1 Style-Adjusted Value Added for Rules-Based Strategies

2 See Clare, Motson and Thomas [2013]. 3 The gray area specifically represents the boundary of a t-statistic of 2.0 or less for alpha relative to a portfolio of the Fama

and French size (SMB) and value (HML) factors.



9. Certain risk factors have outperformed in the long run Over long periods of time, value strategies have generally performed better than the market across many stock markets worldwide, though also with extended periods of underperformance.4 Figure 2 shows the performance of U.S. stocks sorted into 25 groups by size (market capitalization) and valuation (measured by book-to-market ratio) over the 1963–2013 period. As shown, small stocks generally outperformed large stocks, and value stocks (especially small value) generally outperformed growth.

Figure 2 Average Returns by Style and Size 1963–2013

Figure 3 Average Annual Returns by Beta/Volatility 1968–2012

Other factors, among them momentum (past winners keep winning) and quality (“better-run” companies outperform), are available for investment. In fact, over 300 different factors have been identified in finance literature.5 Value, small, and low volatility, however, are the primary factor exposures currently found in many of the most common institutional smart beta strategies.

4 See Fama and French [2014]. 5 See Harvey, Liu and Zhu [2014].

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5.0%

7.5%

10.0%

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Potentially attractive factors have high absolute and risk-adjusted historical returns, low correlation with other parts of the portfolios, and a large body of credible evidence (research) showing they exist and why.

Factor investing is nothing new. Some combination of broad equity market, bond duration, credit, and liquidity risk factors are found in nearly every institutional portfolio. (Indeed, the value, small, low volatility, and other factors are included in broad equity portfolios, too.) But traditional factors deliver investors primarily a return premium for bearing risk, while the story for value and other more exotic factors is somewhat more complicated.

8. Factor outperformance is driven by market mistakes and risk The simplest way to explain the value premium is this: Investors become too optimistic about favored stocks and bid up their prices too much, only to see them fall back later toward fair value. Value-oriented investment strategies earn excess returns by exploiting this situation. This is a market mistake, or inefficiency. But value stocks might also have higher returns because they are riskier. For example, they might be more prone to financial distress, or less liquid. Compensation through higher expected returns for taking on more risk is a risk premium.

The low-volatility effect (i.e., low-volatility stocks outperform high-volatility stocks) is related to the value and other risk factors. But it is also probably driven in part by behavioral factors like investment managers’ focus on benchmark-relative performance, which may deter them from investing in low-volatility, high tracking-error stocks.6

The distinction between the two reasons—risk premium or inefficiency—for historical outperformance has implications for how investors might access the extra returns, and whether or not they will persist in the future.

Risk premiums are attractive only if they are big enough. But risk premiums can usually be obtained without much skill and aren’t necessarily at risk of disappearing.7

Inefficiencies, on the other hand, are attractive because they potentially translate to extra returns (and potentially without much extra market risk) if investors can exploit them. But it generally takes skill to exploit inefficiencies—and they can disappear if enough people recognize and act on them.

7. Many risk factor return premiums have survived for a long time—but their vital signs need ongoing monitoring The value, small, and low-volatility effects have existed for the past several decades despite general awareness of their existence among the investing public. Perhaps this is because they are a form of compensation for real risks, are deeply rooted in how investors behave, or haven’t yet been fully exploited by investors. If factor-based strategies continue to attract assets, this may put pressure on the associated premiums. Low volatility-oriented assets in particular have increased dramatically since the global financial crisis.

6 See for example Baker, Bradley, and Wurgler [2011]. 7 Empirical evidence shows that certain risk premiums associated with “systematic” sources of risk, while cyclical over short

horizons, have generally been positive over long time periods. Their cyclicality may in fact be one of the reasons they have not been arbitraged away.



Investors who choose to try to exploit these factors—especially with narrower strategies that focus on them individually—must keep an eye on their continued health. This may be challenging, even more so in an extended period of underperformance. Investors should demand ongoing reporting on the prospects for the relevant risk premiums from their managers, who may need to adjust their strategies to adapt to market conditions. Managers should even be willing to shut down strategies if the risk premiums they exploit show signs of disappearing permanently.

6. Factor strategies go in and out of favor Regardless of performance drivers, risk factor strategies—as with other investment types—go in and out of favor for extended periods of time. This presents a risk, but also an opportunity—as skilled investors can add value by being dynamic in their approach. A dynamic approach can be implemented by using active equity managers who incorporate value, low volatility, and other factors into a broader strategy, or by the asset owner or multi-asset manager using style-focused strategies to express market views.

5. There are several possible approaches to factor investing; some of them may already be in your portfolio Smart beta is a way of applying factor investing techniques to a broad stock portfolio in a systematic manner. But there are several other ways to attempt to profit from factors.

Style index funds that focus on subsets of the broad market (but are market cap-weighted) have been available for many years.

Quantitative managers often employ factor approaches expressed through skill-based and adaptive model building.

Many fundamental active managers also use similar approaches to select securities, and have significant factor exposures in their return patterns.

We recently described opportunistic deep value investing, where investors seek to exploit significant mispricing of certain assets.8

In general, entire asset classes can experience “mis-valuation,” from which clients can potentially profit using medium-term views.

Investors need to balance the costs and benefits of each potential approach.

4. Investors should measure their active risk and make sure they are being compensated for it There is an ongoing debate as to whether smart beta strategies are active, passive, or something in between. In practice, virtually all investments are active. An investor’s position in a market cap-weighted equity index fund is an active bet on the equity risk premium. A style index fund, or smart beta portfolio, is an active bet on a collection of risk factors. A traditional active equity manager combines all the above, plus an active bet on that particular manager’s skill.

8 See Scotto [2014].



Investors should measure the overall active risk in their investment programs, whatever the sources. Then they should seek to answer these questions: “Am I comfortable with the overall level of risk in the program and its sources?” And, “Do I expect to be compensated appropriately—through risk premiums, factor returns, and profits from skill—for those risks?”

3. Not all smart beta is created equal Investors may choose from a wide and diverse set of smart beta strategies. They generally deliver a combination of factor exposures. However, the type and size of those exposures vary by strategy, and other factors (whether intended or not) may be present as well. Likewise, strategies differ in rebalancing methodology, fees, trading costs, and other dimensions. Most adhere closely to a set of fixed, transparent portfolio construction rules, but some have a greater degree of manager discretion—often crossing the line into traditional active management.

Smart beta investors are generally buying a specific portfolio strategy—not the perceived skill of a team or a complex investment process—so those specifics need to be closely examined in the investor’s due diligence process.

2. Adaptive skill is the best way to obtain potentially above-market returns The historical outperformance of factor strategies versus traditional market cap-weighted indexes is due at least in part to market inefficiencies. Exploiting market inefficiencies is an endeavor that generally requires significant investment skill, including the ability to adapt to complex and changing market conditions. Broad, less constrained mandates, which may incorporate value-oriented as well as other strategies, have been shown to be the active management approach with the greatest odds of success. Factor investing, like other forms of equity investing, may benefit in particular from relaxing the long-only constraint.

We know that the average traditional active manager generally underperforms the benchmark—so how can a narrower, rules-based smart beta strategy outperform it?

First, the average active manager simply may not be able to successfully exploit factor premiums, even when they are widely known and can be harvested with mechanical strategies. Average managers’ investment philosophies may lead them in a different direction from value and other factor-related strategies. They may not be able to capture factor premiums as efficiently as even a simple strategy can. Or they may diminish any gains from factor premiums through other unsuccessful trades. Our previous research suggests that as few as 2% of traditional active managers exhibit skill that can be distinguished from investment style or luck.

Second, adaptive investment management skill is expensive in terms of higher fees and trading costs. The cost gap between a cheaper (but well-founded) and a more expensive strategy can make the difference between outperformance and underperformance.

We believe that a well-chosen and structured set of exposures to attractive risk factors will outperform the average manager.



1. The right portfolio depends on your investor suitability factors: return objectives, tolerance for risk and cost, and oversight resources The most impactful portfolio changes an investor can make will almost always be in the area of overall asset allocation and ensuring optimal diversification. Investors should begin by reviewing their circumstances and objectives, including “suitability” for highly active investments, and ensuring that broad high-conviction asset categories like liquid and illiquid alternatives are represented appropriately for their portfolio’s size, time horizon, and governance resources.

Within the equity portfolio, investors have the tools to suit a wide variety of investor characteristics.

Market cap-weighted index funds seek to provide low-cost market returns with minimal implementation risk. Efficiency-minded investors, who wish to minimize cost and complexity while seeking to outperform the average equity investor, will be well served here.

Smart beta and other risk factor approaches are attractive tools for investors with the governance resources to skillfully select and monitor investment strategies and the desire to seek added value versus market cap-weighted indexes, but who want or need to reduce implementation cost or reliance on traditional active equity management. This may include large, sophisticated investors who, by virtue of their size, operate within capacity constraints.

Smart beta may also fill a factor exposure need in a portfolio; for example, to eliminate an unwanted style bias.

Factor strategies are also a potential tool to express views on various market segments, allowing dynamic application of medium-term views.

Traditional active strategies have come under fire recently, but skilled managers have the potential to add value, especially in an unconstrained or concentrated mandate. As such, investors with tolerance for costs, the access to manager selection skill, and the patience to stay with high-conviction strategies for the long term may find traditional active attractive. (Keep an eye, however, on the value your manager adds after accounting for any persistent factor exposures he/she may have.)

Expanding high-conviction active equity management into the equity alternatives space further increases the potential for alpha and reduced equity market exposure by loosening the long-only constraint9. Investors with maximum suitability for active investing may find the greatest fit with a combination of hedge fund and high-conviction traditional mandates. Cost-conscious investors should be aware that alternative investments come with materially greater fees and potentially additional risks associated with the use of derivatives, leverage, illiquidity, etc.

9 While smart beta strategies can be implemented via long-only or long-short approaches, in our view, equity hedge funds are likely

the most effective at market timing, risk premium timing, and stock selection—investment skills that are not easily captured by rules-based indices.



For investors considering enhancements to their equity portfolios, Figure 4 lays out a set of decision tools to map their options.

The tools relate to three potential starting points: 1) enhancements to a portion of the equity portfolio that is currently invested in a market cap-weighted index fund; 2) in a typical active manager; or 3) in a high-conviction active portfolio. It considers shifts among these categories and to two of the most common rules-based (smart beta) strategy types. It is strategic in nature and does not consider current views the investor may hold regarding the near- or medium-term prospects for value, low volatility, or other factor strategies—or active management in general.

Figure 4

A. Considerations Starting With a Market Cap-Weighted Index Fund

Rules-Based Traditional Active

Switching to…

Market Cap Index Fund

Value/ fundamental

Low volatility Typical

High conviction10

Equity Alternatives

Potential return opportunity (net)

Higher if factor premiums persist

Higher if factor premiums persist

Lower Significantly higher

Significantly higher

Volatility Similar Lower Similar Similar Lower Tracking error/ risk of underperformance

Higher Significantly higher

Higher Significantly higher


Cost Similar Similar Higher Higher Higher Oversight requirements11

Higher Higher Higher Higher Significantly higher

Consider switching if you have:

Higher return objectives; cost constraints; aversion to high active risk

Higher return objectives; cost constraints; desire to reduce market exposure

Don’t switch Higher return objectives

Higher return objectives; desire to reduce market exposure

10 “High conviction” refers to a highest-rated, as opposed to typical, active strategy. Such strategies are typically broader in mandate

and less constrained, and are often more concentrated, taking higher active risk relative to the benchmark. 11 Oversight requirements refer to the selection and monitoring of traditional active managers and of specific rules-based strategies.



B. Considerations Starting With a Typical Active Manager


Switching to… Market Cap Index Fund

Value/ fundamental


High conviction12

Equity Alternatives


Higher Higher Higher Significantly higher


Volatility Similar Similar Lower Similar Lower Tracking error/ risk of underperformance

None Similar; higher in crisis




Cost Lower Lower Lower Similar Higher Oversight requirements

Lower Similar Similar Similar Higher


Higher return objectives

Cost constraints; aversion to high active risk

Cost constraints; desire to reduce market exposure

Switch Desire to reduce market exposure

C. Considerations Starting with a High-Conviction Active Manager


Switching to… Market Cap Index Fund

Value/ fundamental


High conviction13

Equity Alternatives


Lower Lower Lower Significantly lower


Volatility Similar Similar Lower Similar Lower Tracking error/ risk of underperformance

None Lower Higher Lower Similar

Cost Lower Lower Lower Similar Higher Oversight requirements

Lower Similar Similar Similar Higher




Cost constraints; desire to reduce market exposure

Don’t switch Desire to reduce market exposure

Investors should begin a review of the equity portfolio with a consideration of overall return objectives, risk tolerance, cost constraints, and their oversight resources. With these considerations in mind, investors should ensure any moves are in the direction of increased efficiency and closer alignment with their circumstances and objectives.

12 “High conviction” refers to a highest-rated, as opposed to typical, active strategy. Such strategies are typically broader in mandate

and less constrained, and are often more concentrated, taking higher active risk relative to the benchmark. 13 “High conviction” refers to a highest-rated, as opposed to typical, active strategy. Such strategies are typically broader in mandate

and less constrained, and are often more concentrated, taking higher active risk relative to the benchmark.



We believe that most investors are best served by a combination of low-cost, market-like returns through market cap-weighted index funds and efficient deployment of active risk. Generally, this means moving away from “typical” active equity management and toward high-conviction traditional active management and equity alternatives.

Profiting from exposure to potentially attractive return factors through rules-based strategies is also a useful approach, particularly for investors with cost constraints, aversion to significant active risk from concentrated portfolios, or a desire to reduce market exposure at relatively low cost in the medium or long term through low-volatility investments. Rules-based or other factor-based strategies may also be used as part of a strategy to express views on various styles.

In all cases, success in producing better outcomes than those of the equity market requires access to skill—either in active manager selection or in identifying and monitoring attractive risk factors.

Investors without access to that skill should construct an efficient, low-cost portfolio that seeks to capture market returns. Those who can exploit that skill may improve their odds of meeting overall investment objectives with careful portfolio construction and a long-term focus.



References Baker, M., Bradley, B., and Wurgler, J. “Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly.” Financial Analysts Journal, Vol. 67, No. 1 (2011)

Bender, Jennifer, Briand, Remy, Melas, Dimitris, and Subramanian, Raman Ayulur. “Foundations of Factor Investing,” MSCI Research Insight (December 2013). Available at https://www.msci.com/resources/pdfs/Foundations_of_Factor_Investing.pdf

Clare, Motson, and Thomas. (2013) “An Evaluation of Alternative Equity Indices. Part 1: Heuristic And Optimised Weighting Schemes,” Cass Working Paper

Clare, Motson, and Thomas. (2013) “An Evaluation of Alternative Equity Indices. Part 2: Fundamental Weighting Schemes,” Cass Working Paper

Fama, Eugene F. and French, Kenneth R. “A Five-Factor Asset Pricing Model” (September 2014). Fama-Miller Working Paper. Available at SSRN: http://ssrn.com/abstract=2287202 or http://dx.doi.org/10.2139/ssrn.2287202

Fiore, Christopher and Saha, Atanu. “A Tale of Two Anomalies: Higher Returns of Low-Risk Stocks and Return Seasonality” (May 2015). The Financial Review, Vol. 50, Issue 2, pages 257-273. Available at http://onlinelibrary.wiley.com/doi/10.1111/fire.12066/abstract

Harvey, Campbell R., Yan Liu, and Heqing Zhu. 2014. “…and the Cross-Section of Expected Returns.” Available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2249314

Jordan, Bradford D. and Riley, Timothy B., “Volatility and Mutual Fund Manager Skill” (February 2, 2015). Journal of Financial Economics (JFE), Forthcoming. Available at SSRN: http://ssrn.com/abstract=2365416 or http://dx.doi.org/10.2139/ssrn.2365416

Scotto, Mike. “Opportunistic Deep Value Investing: A Multi-Asset Class Approach.” Aon Hewitt (2014)

The opinions referenced are as of the date of publication, are subject to change due to changes in the market or economic conditions, and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice. Past performance is no guarantee of future results.

http://ssrn.com/abstract=2287202

http://dx.doi.org/10.2139/ssrn.2287202

http://onlinelibrary.wiley.com/doi/10.1111/fire.12066/abstract

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2249314

http://ssrn.com/abstract=2365416

http://dx.doi.org/10.2139/ssrn.2365416



Contact Information Mike Sebastian Partner Aon Center for Innovation and Analytics +65 6645 0122 [email protected] Sudhakar Attaluri Associate Partner Aon Hewitt Investment Consulting +1.312.381.1317 [email protected]

mailto:[email protected]

mailto:[email protected]



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10 insights on rules-based and factor investing · 10 insights on rules-based and factor investing...

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