Factor investing has entered the main stream – although not without some controversy. As an institutional investor without any exposure to “smart beta” or factor indices we have the luxury of watching from the sidelines as (recently) luminaries such as Rob Arnott (from the PIMCO affiliated Research Affiliates) and Cliff Asness from AQR spar on the long term merits of factor investing. Mr. Arnott claims it is just a valuation game – that certain factors become popular because they are undervalued and then proceed to unravel once they are noted as “trading rich”. He somewhat controversially alleges that there is a risk of “academic bubbles” that tap into “almost exactly the same elements of the human psyche as market bubbles”. His central belief is that things revert to the mean and that, therefore, a correction can be expected after a factor has run up.
AQR’s view is that factors have their own merits, and that things can remain undervalued for some time. Thus an over-emphasis on valuation is not a good idea for those attempting to time factor exposures. Their products tend to have constant exposure to a balanced range of factors and they do not attempt to time entry or exit into such strategies – citing the age-old dilemma surrounding the efficacy of market timing.
We saw a fascinating presentation recently which claimed that factor investing was in fact nothing new – that it simply recycled long held investing styles and marketed them under a fancy new banner. We tend to agree. Whether the valuation point made by Mr. Arnott though is a valid one bears some analysis and monitoring. Just this week, in the financial times, Gillian Tett suggested that ETF’s might be the next spark to incite a global financial crisis. She cites the explosion in the sector – which now has over $4 trillion in assets globally (larger than the hedge fund universe) and representing close to 60% of the asset management industry in the US. Just today we learned of another casualty (in our portfolio) of this widespread shift – a boutique minority run firm has decided to close its doors in light of ongoing asset losses. There is no question that passive investments have distorted flows (as well as created the run-up in tech stocks such as the FANGs) and probably account for the divergence in growth and value performance this year (the gap ranges from 900 bps to 1200 bps in the US). Over coming weeks, spurred by the 10th anniversary of the 2007 unraveling, we will begin to hunt for signs of trouble – “time bombs” in the words of Gillian Tett – and will report them here.