April 2015 An Institutional Investor Sponsored eBook

FACTOR

INVESTING

From Concept to Implementation

By Chris Wright

Sponsored eBook

INSIDE

Factor Investing

2 Institutional Investor eBook Sponsored by Robeco April 2015

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actor investing is an approach that has its roots in academic

research from as far back as the 1970s, but only now is being used
in its most effective form. It uses ideas such as value, momentum
and low-volatility, but combines them into a model that gives
much stronger risk-return outcomes than many other investment
methods. In this guide, Robeco, one of the leaders and pioneers in factor
investing, explains how it works and how it is best implemented.
Chapter 1: What is Factor Investing?.............................................................4
Chapter 2: The Robeco Philosophy................................................................8
Chapter 3: From Concept to Implementation........................................... 12
Summary........................................................................................................ 16
Contact Information..................................................................................... 16
About Robeco................................................................................................ 17

April 2015 Institutional Investor eBook Sponsored by Robeco 3

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CHAPTER 1

What is Factor Investing?

4 Institutional Investor eBook Sponsored by Robeco April 2015

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actor investing is attracting increasing attention as an effective and

evidence-based investment model. But what exactly does it mean?
Its good to start with terminology, says Joop Huij, Head of
Factor Investing Research at Robeco in Rotterdam. The tricky
thing with factor investing is that multiple terminologies are used that
refer to the same thing. The terms smart beta or risk-based investing are
sometimes used to describe a similar philosophy.
So what do we mean by factor investing? To understand it, we first have
to know what a factor is, and the established investment ideas that factors
challenge. For years, many investors have been keen disciples of whats
known as the efficient market hypothesis, which states that it is impossible to
systematically outperform the market because the efficiency of stock markets
causes them to reflect all the relevant information around them at any given
time. To put it another way: stocks always trade at their fair value, and theres
no such thing as a stock being undervalued or overvalued.
But since the 1970s, a growing body of empirical academic research
has challenged this idea. There is a stream of literature that shows
returns from different parts of the market cannot be attributed to
differences in market risk, says Huij, and the consequence of that is
that sometimes, it is possible to earn return higher than the market.
Some of the most important examples of this are the value segment,
the momentum segment, and the low-volatility segment of the market.
These are factors, and there is an overwhelming amount of academic
evidence showing that they earn returns higher than you would expect
them based on the market risk involved.
April 2015 Institutional Investor eBook Sponsored by Robeco 5

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CHAPTER 1

But identifying what a factor is is only the start.

Factor investing involves taking these factors
and using them intelligently and collectively in
an investment strategy. And, given the wealth of
academic literature that is available to demonstrate
that factors exist, attempts to incorporate them
intelligently in an investment process are surprisingly
recent developments.
One could argue that the idea as an investment
discipline
stems from an influential report published
Joop Huij, Head of Factor
by
the
government
of Norway in 2009, through
Investing Research
Norges Bank Investment Management, after its
vast sovereign wealth fund, now called Government Pension Fund Global,
suffered badly in the global financial crisis in 2008. The government wanted
to understand: why is this? Is the way that we manage our wealth the most
efficient way to do it?
Norways approach was not just to ask established asset managers, but
academics: Professors Ang, Goetzmann and Schaefer of Columbia University,
Yale University and the London Business School respectively. Their
conclusions were extremely comprehensive its one of the few reports I
know with a summary of the summary, says Huij and so groundbreaking
that factor investing is now sometimes known as the Norway model, even
though Norway didnt immediately adopt any of the findings.
The reports most significant conclusion was that as much as two thirds
of outperformance could be attributed to the market segments we now call
6 Institutional Investor eBook Sponsored by Robeco April 2015

tors
by three
with
d the
e study
nce of
mproving

ve
ain
n
fund
uch
wards
rket.
d be, for
e value
his
ure 1.

cial
in
olor,
n in any
tment
s by
bonds

Sponsored eBook

ratio versus those with a low ratio), and the

high-momentum versus the low-momentum
segment (i.e., equities with high return over
the last 12 months versus those of which
returns were low). Finally, the portfolio should
be concentrated in those market segments in
In Diagrams 4 and 5 we show how factor
which the expected returns are most attractive:
investing for equities can be implemented
factors.
The academics therefore made the
anlow-volatility
influentialsegment,
recommendation,
the value segment
within an investment portfolio. First, the asset
which
Huij
summarizes
as:
why
not
directly
allocate
to these
segments
and the high-momentum
segment.
If you in
classes should not be split up into regions,
abutstrategic
allocation,
instead
of
hiring
an
asset
manager
and
hoping
now compare Diagram 3 with 5, you see they
that
into segments. These are precisely those
the expected return
thewe
factor-investing
segments
whereaccess
academictoresearch
has market segment?
will
provide
the right
Andfrom
here
come to the
portfolio
in Diagram
5 is higher
thanimpact
that of
shown that significant
return
differentials
definition
of factor
investing:
not just being
aware
of how
factors
the
traditional
portfolio
in
Diagram
3.
can
be
expected,
such
as
the
low-vol
versus
performance, but taking responsibility for allocating towards them from
high-vol segment; the value versus glamour
the outset. l
segment (i.e., stocks with a high price-to book
this area, and if they do find added value, this
can often be attributed largely to the fact that
consciously or unconsciously the manager
capitalizes on classical factor premiums.

Figure 1: Strategic allocation based on factor investing

Strategic
allocation based on factor investing
1. Traditional strategic asset allocation

3. Search for skilled managers (alpha)

Equities
Japan
Government
bonds

Equities
Japan

Equities
Europe

Government
bonds

Equities
Europe

Government
bonds

Equities

Equities U.S.

Equities U.S.

Credits

Legend

he long
s than
enerally
United

of
While
average
ble for

2. Traditional break-down in regions

Risk-adjusted
expected return
low

Credits

Credits

Equities Low
Volatility

Eq. Lo.Vol.
Eq. Hi.Vol.

Equities
High
Momentum

Government
bonds

Eq. Hi.Val.

Equities

Equities
Credits

Source: Robeco.

Government
bonds

Eq. Hi.Mom.
Eq. Lo.Val.

Equities
High Value

high

Eq. Lo.Mom.

5. Strategically allocate to factor premiums

Credits

4. Factor premiums drive alpha

April 2015 Institutional Investor eBook Sponsored by Robeco 7

Several large professional investors have

This is probably linked to the size and

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CHAPTER 2

The Robeco Philosophy

8 Institutional Investor eBook Sponsored by Robeco April 2015

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obeco does not claim to have invented factor investing, but it does have
a distinctive philosophy about what to do with the idea. The three
professors came up with it, but only as a theoretical framework, says
Huij. The question is how to bridge the gap between this theory and
the reality of setting up investment vehicles.
Robecos philosophy starts with recognizing the statistical evidence supporting
the effectiveness of factor investing. There is a lot of evidence suggesting
that this approach is more effective than, for example, just active or passive
management, he says.
But it is not enough to be aware that this statistical preference exists. It is even
more important to know why it exists, and to incorporate these insights into the
investment process. If you really understand what you are doing, this can help
you to get more efficient exposure to factors, and to set up a better investment
product.
To understand this in practice, lets look closely at one factor: value.
Its not exactly a revelation to learn that value investing the idea that cheap
stocks, such as those on a lower than average price earnings ratio, will eventually
be rewarded with above-market returns - is popular. The subject is part of the
CFA curriculum, and has been studied by academics as noted as Nobel laureate
Eugene Fama. There are thousands of studies that show the value effect exists,
but if we look at studies of why this is a factor, there are very few, says Huij. If
we look at the work of Professor Fama, he shows overwhelming evidence for
the existence of the value effect, but only one paragraph about the potential
explanation for what he observes.
Robeco believes this leads to some unfortunate practices. As a result of the
April 2015 Institutional Investor eBook Sponsored by Robeco 9

Sponsored eBook

CHAPTER 2

lack of research on why the value effect exists, many people think that risk is
the only determinant in deciding a return. They think that they must therefore
buy stocks that are cheap, without necessarily observing that some stocks are
cheap for a reason, and thinking about what that reason might mean for future
performance. If a generic value strategy would be formed at this moment, it
would be strongly overweighted financials in southern European countries and
real estate, just because these are really risky and their price has gone down a
lot, says Huij. People think its all part of the plan: that they must take risk to
get a value premium.
Robeco, by contrast, wants to do more than just identify what a factor is.
Its Quantitative Research team has studied data for many years, testing for
causality rather than correlation, and could not find any proof that taking
distress risk automatically leads to compensation in value premium. We could
find no causal relationship between taking extra risk and earning the value
premium, he says. And that is what we think investors should consider when
implementing a value strategy: its not necessary to take a lot of risk to earn that
value premium.
The Robeco approach, then, is to develop technology to take out the
unrewarded risks and retain the premium. I like to refer to it, says Huij, as
efficiently harvesting factor premiums.
Robeco has taken similarly rigorous approaches to other key factors, such as
momentum and low-volatility. In momentum which holds that stocks that
have been performing well will continue to do so even when fundamentals
dont necessarily suggest they should Robeco found that half of the risk
intrinsic to a momentum strategy does not contribute to its return, and can
10 Institutional Investor eBook Sponsored by Robeco April 2015

eBook
Across the board, the improvements Sponsored
in the Sharpe
ratios come from both an increase in
Across the board, the improvements in the Sharpe ratios come from both an increase in
return and a decrease in risk. The risk reductions are largely due to avoiding unrewarded
return and a decrease in risk. The risk reductions are largely due to avoiding unrewarded
risks, as described earlier. The risk budget that is released by avoiding the unrewarded risks
risks, as described earlier. The risk budget that is released by avoiding the unrewarded risks
also enables the efficient approaches to seek higher exposures to the factor premiums (i.e.,
also enables the efficient approaches to seek higher exposures to the factor premiums (i.e.,
through higher concentration and active share) resulting in higher returns. For instance,
through higher concentration and active share) resulting in higher returns. For instance,
whereas the MSCI Value Weighted index has an active share of only about 25%, the
whereas the MSCI Value Weighted index has an active share of only about 25%, the
corresponding figure for the Robeco Value strategy is around 90%.
corresponding figure for the Robeco Value strategy is around 90%.

The returns are also higher because of differences in exposures to other factors. For
The returns are also higher because of differences in exposures to other factors. For
example, the MSCI World Value Weighted and the MSCI World Minimum Volatility indexes
example, the MSCI World Value Weighted and the MSCI World Minimum Volatility indexes
both exhibit a negative exposure to the momentum premium, whereas the efficient factor
both exhibit a negative exposure to the momentum premium, whereas the efficient factor
premium strategies are designed to avoid negative exposures to other factor premiums.
premium strategies are designed to avoid negative exposures to other factor premiums.
be
stripped
halving
strategys
volatility
retraining
In the
Based
on theout,
above
results,the
we can
conclude
that the while
added value
of our returns.
research insights
Based on the above results, we can conclude that the added value of our research insights
low-volatility
field,
which
argues
that
low-risk
stocks
have
higher
risk-adjusted
is sizable.
is sizable.

returns, Robeco research found that the strategy works particularly well in the
most
liquid stocks,
among other findings.
Confirmed
Confirmed by
by live
live track-records
track-records
Aslive
thetrack-records
next chapter
discusses,
thevalue
otherofkey
element
the Robeco
Our
confirm
the added
Robeco
factorof
strategies.
As table 3
Our live track-records confirm the added value of Robeco factor strategies. As table 3
philosophy
is good
a process
that is different
for every
client.
shows, our factor
fundsimplementation,
have not only handsomely
outperformed
the regular
capitalizationshows, our factor funds have not only handsomely outperformed the regular capitalizationRobeco
offers
fully-fledged
solutions
to
investors,
including
implementation;
weighted index, but also their corresponding factor indices. We note that these results or
weighted index, but also their corresponding factor indices. We note that these results
sometimes,
forbetter
sovereign
funds, anbasis,
advisory
role onfor
a strategy
which the fund
would be even
on a risk-adjusted
in particular
our low- volatility
would be even better on a risk-adjusted basis, in particular for our low- volatility
itself
can thenEquities)
choosestrategies,
to implement.
Thelived
key,up
though,
understanding
the
(Conservative
which have
to theirispromise
of delivering
a much
(Conservative Equities) strategies, which have lived up to their promise of delivering a much
clients
needs and
portfolio. l
lower volatility
thanexisting
the capitalization-weighted
index.
lower volatility than the capitalization-weighted index.

Table performance
3. Live performance
Robeco factor
strategies
versus MSCI
factorMSCI
indices
Live
Robeco
factor
strategies
versus
Table 3. Live performance
Robeco factor
strategies
versus MSCI
factor indicesfactor indices

Start month
Start month
Versus regular index
Versus regular index
Robeco
Robeco
MSCI
MSCI
Excess return
Excess return
Versus factor index
Versus factor index
Robeco
Robeco
MSCI
MSCI
Excess return
Excess return

Value allValue allcountry

country
Jan 2014
Jan 2014

Momentum allMomentum allcountry

country
Sep 2012
Sep 2012

Low-vol
Low-vol
developed
developed
Oct 2006
Oct 2006

Low-vol
Low-vol
emerging
emerging
Mar 2011
Mar 2011

10.58%
10.58%
6.86%
6.86%
3.72%
3.72%

18.96%
18.96%
15.18%
15.18%
3.78%
3.78%

7.21%
7.21%
4.30%
4.30%
2.91%
2.91%

10.30%
10.30%
1.29%
1.29%
9.01%
9.01%

10.58%
10.58%
6.66%
6.66%
3.92%
3.92%

18.96%
18.96%
13.55%
13.55%
5.40%
5.40%

7.21%
7.21%
4.63%
4.63%
2.57%
2.57%

10.30%
10.30%
7.68%
7.68%
2.62%
2.62%

Source:
Robeco,
MSCI.areReturns
areand
gross
of fees
and annualized
periods
longerEUR.
than
12through
months.
Base
currency:
Source:
Robeco,
MSCI. Returns
gross of fees
annualized
for periods
longer than 12 for
months.
Base currency:
Data
30 June
2014.
Source:
Robeco,
MSCI. Returns
are gross
of fees
and annualized
for
periods
longerValue-Weighted,
than
12 months.
Base
currency:
Strategies
are: Robeco
Quantitative
Value,
RobecoStrategies
Momentum and
Robeco
Conservative
Equities. Indices
are MSCI
MSCI Momentum
EUR. Data
through
30 June
2014.
are:
Robeco
Quantitative
Value,
Robeco Momentum
and Robeco
EUR.
through
2014.
Strategies
are: Robeco
Quantitative
Value,
Robeco
and
MSCIData
Minimum
Volatility30
(net June
return).The
value
of your investments
may fluctuate.
Results obtained
in the Robeco
past are noMomentum
guarantee for theand
future.

Conservative Equities. Indices are MSCI Value-Weighted, MSCI Momentum and MSCI Minimum Volatility (net return).
Conservative Equities. Indices are MSCI Value-Weighted, MSCI Momentum and MSCI Minimum Volatility (net return).
The value of your investments may fluctuate. Results obtained in the past are no guarantee for the future.
The value of your investments may fluctuate. Results obtained in the past are no guarantee for the future.

April 2015 Institutional Investor eBook Sponsored by Robeco 11

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CHAPTER 3

Concept to Implementation

12 Institutional Investor eBook Sponsored by Robeco April 2015

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nce a client has accepted that factor investing would be useful,

how does it go about implementing it?
We dont believe there is one optimal solution or allocation
for all investors, says Huij. We think two things should be taken
into account when constructing a factoring solution.
The first is the preferences of the individual investor. For example, we
see big differences between the preferences of pension funds and sovereign
wealth funds, Huij says. Pension funds are worried about coverage ratios,
liabilities, and have a relatively shorter time horizon; sovereign wealth
funds have different risks to worry about, such as inflation. First you have
to identify which factors are relevant, and then come up with the optimal
weights.
The second is knowing whats already there. Something thats often
ignored is the exposure an investor already has in his or her portfolio,
says Huij. If a sovereign wealth fund already has exposure to value, why
add value investing in the solution you create for an investor?
Robeco gets around this danger of overlap with the software it has
developed. Through it, it can work with clients, monitor exposures
throughout the portfolio, and make recommendations accordingly. We
can build around the exposures they already have in place. This is the way
factor investing portfolios should be built: referencing the exposures that
are already there.
Robeco has tested a wide range of different combinations of factors. An
equally-weighted model, for example, would put one third each into value,
momentum and low-volatility strategies. A maximum return model,
for an investor more concerned about outright returns than matching
April 2015 Institutional Investor eBook Sponsored by Robeco 13

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CHAPTER 3

liabilities, for example, would ignore low-volatility and instead split the
allocation between value and momentum. A pension fund, which has to
worry about coverage ratios, might favour a minimum volatility model. A
risk-weighted model could be 30% apiece in value and momentum, and
40% in low volatility. Robeco has tested all
of these models and found each of them
delivers both outright outperformance
and just as important considerably
improved returns relative to volatility. The
conclusion is that factor investing should
be beneficial in any interpretation, but that
there is no single optimal factor-investing
portfolio that will fit every investor.
Factoring is, chiefly, an institutional story
because of this need for customization,
but some of the ideas within it can be
applied to retail. Robeco, for example, has
created a product solution which brings
together some of the flavors that appear
Low-Volatility Investing:
Collected Robeco Articles
most frequently in factor investing. That
is offered to retail and wholesale investors,
ORDER HERE
says Huij. But the main target audience
will remain large institutions.
As it has worked with institutions, Robeco has learned that there is a
lot to be gained from the approach. As we have performed many factor
scans with large institutions, it is quite intriguing, says Huij. There
14 Institutional Investor eBook Sponsored by Robeco April 2015

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Combining factors
Finally, we consider various approaches to constructing factor-premium portfolios. Table
Finally, we consider various approaches to constructing factor-premium portfolios. Table
4 below shows the performance of different combinations of the value, momentum and
4 below shows the performance of different combinations of the value, momentum and
low- volatility factors. We consider an equally-weighted (1/N) portfolio, a maximum-return
low- volatility factors. We consider an equally-weighted (1/N) portfolio, a maximum-return
portfolio, a minimum-volatility portfolio and a risk-weighted portfolio. For the maximumportfolio, a minimum-volatility portfolio and a risk-weighted portfolio. For the maximumare
typically
big adifferences
between of
what
isand
optimal
and what
they that
return
portfoliovery
we take
fifty-fifty combination
value
momentum,
assuming
return portfolio
we
take a fifty-fifty
combination
of value
and
momentum,
assuming
that
actually
have.
It
comes
down
to
implementing
the
solution,
and
allowing
these factors have the highest future expected return. The minimum-volatility portfolio is
these factors
have their
the highest
future to
expected
return.
The minimum-volatility
portfolio is
them
to change
exposures
what the
optimal
should be for that
fully invested in the low-volatility factor. The risk-weighted portfolio weighs the individual
fully
invested
in
the
low-volatility
factor.
The
risk-weighted
portfolio
weighs
the
individual
client. That suggests a great deal of opportunity for institutional investors
factor strategies by the inverse of their long-term volatility, thereby establishing equal
factor
strategies
by
the
inverse
of
their
long-term
volatility,
thereby
establishing
to benefit from this exciting and rigorous investment approach. l equal
risk contributions. In unreported tests, we constructed several other portfolios, including
risk contributions. In unreported tests, we constructed several other portfolios, including
portfolios optimized in-sample for maximum Sharpe ratio or maximum information ratio.
portfolios optimized in-sample for maximum Sharpe ratio or maximum information ratio.

Performance
ofperformance
different combinations
of efficient
factor factor
strategies
Table 4. Portfolio
of different combinations
of efficient
strategies

Table 4. Portfolio performance of different combinations of efficient factor strategies

Equally
Maximum
Minimum
Risk
Equally
Maximum
Minimum
Risk
weighted
return
volatility
weighted
weighted
return
volatility
weighted
Absolute
Absolute
Return
12.9%
13.2%
12.2%
12.8%
Return
12.9%
13.2%
12.2%
12.8%
Volatility
13.5%
14.8%
11.6%
13.3%
Volatility
13.5%
14.8%
11.6%
13.3%
Return/volatility
0.95
0.89
1.05
0.96
Return/volatility
0.95
0.89
1.05
0.96
Relative
Relative
Outperformance
5.3%
5.6%
4.5%
5.2%
Outperformance
5.3%
5.6%
4.5%
5.2%
Tracking error
4.9%
4.7%
7.1%
5.1%
Tracking error
4.9%
4.7%
7.1%
5.1%
Information ratio
1.06
1.19
0.64
1.02
Information ratio
1.06
1.19
0.64
1.02
Factor allocation
Factor allocation
Value+
33.3%
50%
30.1%
Value+
33.3%
50%
30.1%
Momentum+
33.3%
50%
30.0%
Momentum+
33.3%
50%
30.0%
Low-volatility+
33.3%
100%
39.9%
Low-volatility+
33.3%
100%
39.9%
Source: Robeco, MSCI. Average returns are calculated geometrically. Sample period: 1988:05-2013:12. Base currency:

Source:
Robeco,
MSCI.
Average
returns are
calculated
period: 1988:05-2013:12.
Base currency:
USD. Based Base currency:
Source:
Robeco,
MSCI.
Average
returns
aregeometrically.
calculatedSample
geometrically.
Sample period:
1988:05-2013:12.
USD.
Based onvalue
simulations.
on
simulations.The
of your investments may fluctuate. Results obtained in the past are no guarantee for the future.

USD. Based on simulations.

Basically, for all of the portfolios

considered,
we observe
an improvement
the
Aprilthat
2015we
Institutional
Investor
eBook Sponsored
by Robeco of
15
Basically, for all of the portfolios
that
we
considered,
we observe
an improvement
of
the
return/volatility ratio from 0.5 for the market portfolio to roughly 0.9 to 1.1 for the various
return/volatility ratio from 0.5 for the market portfolio to roughly 0.9 to 1.1 for the various

Sponsored eBook

Summary

here is considerable evidence that factors work; now, this

research is being accompanied by investment strategies that take
advantage. Institutional investors can, through factor investing,
avoid risks that dont reward them with returns. Instead, they can
gain market-beating premiums for the lowest possible amount of risk.
As more and more investors realize the advantages of factor investing,
we should expect to see them implement its lessons not just as an
afterthought but a top-down matter of overall investment strategy.
Contact Information
If you would like to know more about factor investing or the solutions
that Robeco offers, please visit www.robeco.com/factorinvesting where
you can also find information on your local contact persons.
Important information
This statement is intended for professional investors. Robeco Institutional
Asset Management B.V. has a license as manager of UCITS and AIFs from
the Netherlands Authority for the Financial Markets in Amsterdam.
Neither information nor any opinion expressed in this document
constitutes a solicitation, an offer or a recommendation to buy, sell or
dispose of any investment, to engage in any other transaction or to
provide any investment advice or service.

16 Institutional Investor eBook Sponsored by Robeco April 2015

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About Robeco

obeco is a global asset manager offering a wide range of

investment products and solutions to institutions and
individual investors. Robeco believes in quantitative research,
sustainability and adding value for clients through constant
innovation.
Headquartered in Rotterdam, the Netherlands, Robeco has offices in
13 countries across Europe, the US, Middle East and Asia Pacific with
key investment centers located in Rotterdam, Zurich, Boston, New York
and Hong Kong.
As at 31 December 2014 Robeco managed over EUR 245 billion.
Robeco and Team Brunel - pioneers with a passion for data
There are many parallels between sailing around the world and
successful investing. Both combine technical know-how with careful
risk management. And both require teamwork to win over the long
term. That is why Robeco was delighted to become sponsor of Team
Brunel, the Dutch entry in the Volvo Ocean Race 2014-15. This roundthe-world race has eight boats competing. It will take nine months
to complete this epic voyage, calling at nine stopover ports along the
route. The sponsorship is a natural fit.
A pioneering spirit has long been embedded in Robecos DNA.
We were the first to take sustainability investing seriously, among the
April 2015 Institutional Investor eBook Sponsored by Robeco 17

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About Robeco

(continued)

first to invest in emerging markets and one of the original users of

quantitative investing models. There is a particular similarity between
factor investing and this race. In order to win, a sailor has many
options. For example, to follow a different route to the rest of the fleet.
In factor investing, it can also benefit you to move away from the
crowd, in this case the market. Doing things differently can pay off. l
Video: Robeco and Team Brunel

18 Institutional Investor eBook Sponsored by Robeco April 2015