Tech can bring sophisticated quant closer to smart beta budget

Globally, recent research has shown that assets allocated to factor-based strategies globally grew 14.5 per cent to $1.8tn (£1.4tn) in 2017 alone, and these allocations have established themselves among the core components of many pensions funds’ investment strategies.

Advances in technology will allow the best factor investors to harness techniques and identify potential return sources that are currently the exclusive preserve of the most sophisticated quantitative managers, bringing them within reach of even highly cost-sensitive pension funds

While the growth in their take-up shows no sign of abating for the foreseeable future, it will be new advances in research and technology that drive more widespread adoption of second-generation factor investing.

Back to basics

First, it is important to define what we mean by factor investing and provide some context for its historical growth.

Factor investing is distinct from traditional discretionary investing in that it combines academically studied drivers of return, such as value, momentum and quality, with quantitative portfolio construction techniques.

In addition to its potential for generating excess returns, two major factors have driven the widespread adoption of factor investing over recent years.

Primarily, factor investing is transparent.

Factor investors can be both more systematic in describing their expected return sources than discretionary investors and more open than traditional quantitative investors.  

Second, factor investing is typically a lower-cost alternative to other forms of active management.  

First generation ‘smart beta’ was particularly important in both these dimensions.  

However, further cost reduction for similar products is likely to be less important for pension fund performance in future, as costs for factor investing are often so low that even cutting fees to zero would add only marginally to final returns.

Back to the future  

Instead, the catalyst for the take-up of second-generation factor investing will be better technology and research.

The new wave of factor investing takes the basic premise of factor investing – transparent, well-studied sources of excess return offered at cost-effective fees – and adds a more sophisticated investment perspective.

Advances in technology will allow the best factor investors to harness techniques and identify potential return sources that are currently the exclusive preserve of the most sophisticated quantitative managers, bringing them within reach of even highly cost-sensitive pension funds.  

Advances in computational power are already bringing far more sophisticated statistical techniques closer to a wider range of managers than ever before. But the next few years will witness an explosion in the application of machine learning techniques such as neural networks to factor investing challenges.  

Big data’s big opportunity

Harnessing big data will also be a huge opportunity.

As experience with big data grows, the generally accepted pool of factors will start to include those derived from big data.  

Already, the pool of potential ‘factors’ is considerably richer than most investors are aware of.

Quantitative investors are using natural language processing – the use of computers to read documents – to change their assessments of a company’s quality, based on, for example, the risks highlighted in financial statements.

It is only a matter of time until factor investors explicitly include these sources of information in their approaches, to the benefit of their end investors.

Meeting the needs of investors

Finally, an underappreciated benefit of factor investing is the way in which it can be tailored to the needs of particular investors.  

Since factor investors seek consistent return sources and build portfolios quantitatively, they can accommodate a range of different needs – whether by varying the geographic mix of their portfolios or altering their risk characteristics.

In the past, as inefficiencies in the investment process have made bespoke approaches prohibitively expensive, tailored methods have been available only to very large pension investors.

However, due to the increasing use of automation and sophisticated quality control software, smaller pension funds will in future be able to request and receive high-quality solutions tailored to their specific needs.

Ashley Lester is head of systematic investments and multi-asset research at Schroders