Factor investing will not dumb down the craft of investing

This article crossed my desk the other day. It was sent by one of the author's, Amin Rajan. in it, Rajan and Pascal Blanqué explain the blurry distinction between passive and active investing. The article first appeared in The Financial Times.

“Truth is rarely pure and never simple,” cautioned Oscar Wilde, the 19th- century playwright. The advice is worth heeding in the current seemingly black and white debate on active versus passive investing. It ignores the rise of a third way, factor investing, that is blurring old demarcations.

Active management appears to deliver the worst of both worlds, according to a recent report (https://www.fca.org.uk/publication/market-studies/ms15-2-2-interim-report.pdf) from the Financial Conduct Authority, the UK regulator: it costs too much and delivers too little. In contrast, passive funds get a thumbs-up.

The end seems nigh for active management. Or does it? The answer is nuanced. There is no nirvana in investing, only phases, as strategies go in and out of fashion.

Passives are cheap, but not cheerful. By tracking traditional market indices such as the FTSE 100 or S&P 500, such funds invariably overweight expensive large companies at the expense of lower-priced small companies. The large ones attract new money owing to their sheer size, not their intrinsic worth. The resulting momentum overinflates market values in the upswing. It also causes extra volatility in the downswing, as subsequent corrections overshoot intrinsic value.

A growing number of institutional investors are switching to a systematic rules-based style of investing, used by quant managers for the past three decades.

Under it, asset classes can be broken down into factors that explain their risk, return and correlation. Factor investing gained traction after traditional diversification became unhinged during the 2008-09 market meltdown, when it was most needed.

Since then, the rise of smart-beta strategies marks a big departure, as investors have sought to remodel their portfolios by allocating assets to risk factors such as value, size, momentum, market, low volatility, term and credit.

Research shows that a high contribution to today’s market-beating returns comes from simple systematic exposure — conscious or unconscious — to these or other factors.

Smart beta is the part of generic factor investing that sits between traditional actives and passives, with clear overlaps at each end. Although rules-based factor investing requires human input as well, it crunches a large volume of data to establish interrelationships between the chosen factors, their risks and their returns.

This is where recent advances in artificial intelligence are set to be a game changer by the end of this decade. The term big data is not new. What is new is its velocity, variety and volume. Reportedly, 90 per cent of all the data in existence today were created in the past five years.

Every new data set is used to reappraise old relationships to create new investible information and actionable insights. Behavioural biases are distinguished from structural anomalies, reason from emotion, and signal from noise. Factor investing is coming of age and causing a trifurcation in the asset industry.

First, the rise in pure passive investing (https://www.ft.com/topics/themes/ Passive_Investing), based on traditional cap-weighted indices, will slow

down, as ever more investors are enticed by the prospect of earning cheap alpha returns at near-beta fees. Lately, traditional passives have disrupted traditional actives. Now the disrupters face the prospect of being disrupted themselves.

Second, factor investing will not dumb down the craft of investing. Portfolio managers will still need to make judgment calls on which factors to select and which data to apply. After all, factors can become overvalued as they attract new money and hit the capacity ceiling above a certain level of assets.

Third, the term alpha will be refined to come in two distinct versions: the commoditised one will refer to market-beating returns that are increasingly targeted by factor investing; and the informational version will seek to beat its commoditised rival by solely relying on managerial skills and proprietary research.

In a typical portfolio, these two versions will compete alongside traditional cap-weighted indices, as factor investing spreads from pension plans to mass market investors. Artificial intelligence is set to industrialise the art of investing and benefit those asset managers who have the necessary technology, scale and reach.

At a time when fees are under pressure, price competition will intensify. Active managers who fail to deliver more than commoditised alpha will be hit by the brutal Darwinian forces sweeping away the distinctions between passives and actives.

Pascal Blanqué is chief investment officer of Amundi Asset Management and Amin Rajan is chief executive of Create Research.