Investors should take note of the debate taking place within the factor investing industry. On one side, are those who support a purist approach to the definition of factors, arguing that factor strategies should be built using factor proxies that undergo rigorous scientific tests. Scientific Beta, the organisation linked to EDHEC Business School, is a vocal supporter of this approach.
On the other side, there are several established providers of factor strategies, including FTSE Russell, MSCI and Research Affiliates, that use more complex factor proxies. For instance, where ‘purists’ would use book-to-price as a proxy for the value factor, these organisations might use proxies that include other accounting measures, such as price to forward earnings or price to cashflow.
However, Scientific Beta has shown that providers have a tendency to review their factor proxies after relatively short periods of time. Rigour, in Scientific Beta’s view, would require proxies to be consistent over time.
Scientific Beta’s CEO, Nöel Amenc, says that this is a false dichotomy (see Strategically Speaking, page 72). He argues that scientific consensus shows that only a limited number of straightforward proxies pass the robustness test. However, strategies based on more complex factor definitions continue to attract assets.
The controversy is partly a result of the growing awareness that factor proxies are imperfect. For instance, the book value of a company does not sufficiently take into account brand value and R&D.
It follows that book-to-price is an imperfect measure of value, although this proxy has undergone intense scrutiny that confirmed its significance.
The fact that it is not a perfect value proxy is no reason to let go of scientific rigour when testing the robustness of a factor strategy. Scientific analysis requires consitency and the use of large samples.
Financial economists are far from fully understanding factors or identifying the best proxies for those factors, so innovation is welcome. But our understanding will only be improved through meticulous research. It will hardly be improved by managers rushing to find quantitative anomalies that can be exploited to offer superior returns. Often, these anomalies are temporary.
Meanwhile, investors in factor strategies should decide their goal. If they pursue outperformance, any clever quantitative strategy will do. But that seems no different from active management. If they seek to exploit systematic market anomalies, they should check that their factor managers pass strict robustness tests.
Carlo Svaluto Moreolo, Senior Staff Writer,
carlo.svaluto@ipe.com
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