OppenheimerFunds Head of Product for Beta Solutions, Mo Haghbin recently spoke with Christopher Polk, a Professor of Finance at the London School of Economics, on the evolution of factor investing and aspects of factor investing that may warrant additional research.

Q: You have been researching investment factors since 2003. Tell us about some of your areas of focus.

A: Actually, I have been studying factor investing since 1993, my first year in the Ph.D. program at the University of Chicago. My research paper for a course I took with Gene Fama proposed the idea, at that time novel, of industry-adjusting his value factor to improve both its performance and our understanding of the factor’s economic origin. I have been researching factors ever since. My recent work links some well-known factors to volatility risk. I am also working on a couple of projects that cover the potential for, and the implications of, crowded trading of factors.

Q: What are some ways investors should be thinking about factor allocations?

A: Diversification across factors brings important benefits, therefore careful construction of robust portfolios is required when thinking about factor allocations. One key aspect of putting a portfolio together is understanding the nature of factor exposures, both within and across asset classes. An excellent example highlighting the importance of this aspect of portfolio construction is reflected in allocations to private equity. That asset class clearly has exposure to a market factor. A more careful look also realizes that GPs typically buy portfolio firms that are trading at a discount but have the cash flow to service significant amounts of debt. Such a strategy implicitly brings exposure to the value and quality factors that is heightened by the use of leverage at the portfolio firm level. Of course, private equity funds charge high fees, so obtaining exposure to those factors in a more cost-efficient manner through multi-factor ETFs seems sensible.

Q: Multi-Factor ETFs or Smart Beta strategies that screen for various factors have become very popular in the past few years. Why is there so much interest?

A: There has been a broad recognition in both academia and practice that a good deal of the performance of active managers comes through their exposure to a small set of empirical risk factors. We have seen this evolution before with the rise of passive indices. Investors don’t want to pay alpha fees for beta performance. In the past, that beta exposure was simply in terms of market risk. Now, we know that there are other dimensions of risk that drive returns and, at least historically, provide risk premia.

Q: Are you worried that increased usage of some of these strategies could diminish or reduce the performance/results? What do you think about the capacity of popular single and multi-factor strategies?

A: Thinking that some of these strategies could have their premia shrink certainly seems reasonable. Even if the factors load on a fundamental risk in the economy, increasing the number of investors who share these risks should make their risk premia shrink. Most academics would grant that the U.S. market risk premium has shrunk since the early 20th century, given increased domestic and foreign investor participation. Lower costs through competition and technological improvements, as well as better education about the consequences of investing in the stock market, are responsible for that increased participation. A similar evolution for factors can be expected.

Q: What part of factor investing needs more research? What is most misunderstood about factor investing?

A: I believe there are two important issues. First, academics and practitioners should continue to focus on providing explanations for factor premia, rational or behavioral. The more we understand why these factors arise, the better we can construct strategies that offer exposure to these factors. The second issue is that we must carefully consider the consequences of the significant amount of money that is being poured into factor investing. Will factor premia shrink or even disappear, or will they cycle as money moves into and out of these factors based on performance? That last aspect is perhaps the most misunderstood. A factor may have significant periods of underperformance, yet still be an attractive investment going forward. As a consequence, a long-term perspective is important in factor evaluation, yet it is often not put into practice.

Christopher Polk is the Head of Department and Professor of Finance at the London School of Economics. Prior to the LSE, Polk taught at Northwestern University’s Kellogg School of Management; he has also been a visiting Professor of Economics at Harvard University and a visiting Professor of Finance at the MIT Sloan School of Management. Polk’s research interests are in asset pricing and include related topics in asset management, corporate finance, behavioral finance and macroeconomics.