Measuring factor exposure can be ambiguous if generic factor definitions are used instead of enhanced versions which are designed to earn superior risk-adjusted returns. In our recent white paper, we show that factor investments may appear unbalanced when viewed through a generic factor lens. However, these same investments can represent a well-balanced and profitable combination in terms of exposure, risk, and performance when considered through a relevant factor lens.
The art of factor investing
Factors have become a staple in the portfolio constructor’s toolkit, where the goal is typically to maintain a consistent balance between factors to manage risk while harvesting the associated alpha. The majority of these successful factors can be grouped under value, momentum, quality, and low risk. At Robeco, we have continuously enhanced these core factor themes, as ongoing innovation helps sustain an alpha edge over generic factors; see Swade et al. (2024)1.
This edge is further amplified by going beyond traditional factor themes and bringing in proprietary signals that exploit short-term dynamics and/or alternative data sources2. To illustrate the efficacy of this combination, Blitz (2024) highlights that around 80% of the outperformance of the Robeco model cannot be explained by generic academic factors3.
Measuring factor exposure
Robeco Quant Equities’ unique factor differentiation has consistently placed it among the top performers in peer group performance comparisons (Blitz, 2024). However, prospects and clients are sometimes puzzled when they try to investigate our factor exposure using market factor analysis tools. For instance, they may diagnose what appears to be a factor imbalance, raising questions about the overall portfolio diversification. In our new paper, we shed light onto this very puzzle.
Specifically, we dive deeper into questions such as: How does one best measure factor exposure? Does it really matter how these factors are defined, or are they all the same? And most importantly, are these the ‘right’ factors for producing alpha?
To explore these questions, we use the Robeco Developed Markets Enhanced Indexing (DM EI) strategy, a global equity factor portfolio, and explore the current state of factor definitions. Figure 1 compares the factor exposures calculated using the z-score methodology on Robeco’s proprietary factor definitions and those of three market-leading providers of factor analysis tools. The comparison reveals that while Robeco’s factors share some common DNA with generic factors, they offer distinctive insights that enhance portfolio outcomes.
Figure 1 – Factor exposures of the Robeco Enhanced Indexing strategy
Source: Robeco Quantitative Investments. Robeco Enhanced Indexing Developed Markets strategy through factor scan methodology of provider A, B and C, and through Robeco’s proprietary factors, as of July 2024. The y-axis shows factor exposure, measured using the z-score methodology.
Importantly, generic factor scans typically do not feature analyst revision factors (let alone short-term or alternative alpha signals), thus missing a crucial part of the overall picture. In the white paper, we further discuss the value of third-party factor scans for evaluating portfolios but also highlight some of their pitfalls. Lastly, we emphasize the importance of diversified and balanced portfolio construction to mitigate unrewarded risk and enhance long-term performance.
More than meets the factor eye
The evolution of factors in both academia and industry is unlikely to slow, let alone stop, and there is no one-size-fits-all approach to measuring factors, exposure to factors, or evaluating the risk and performance contribution from them. While the market offers powerful tools to analyze portfolios based on factor lenses, these tools are primarily designed to explain well-known risks. For asset managers focused on generating alpha, ongoing innovation within factor themes is essential – this includes integrating alternative data and short-term signals to capture unique return-enhancing exposures that might be missed by standard, generic scans.
Effective portfolio construction stems from a comprehensive understanding of how exposures manifest as portfolio risks. And although factor scans remain an important tool in a well-researched investment process, variations observed in factor scans should only be a concern if they are not well understood. Two decades on, the success of our Enhanced Indexing portfolios in both developed and emerging markets supports this stance – showing there is surely more than meets the factor eye.
Footnotes
1 Swade, A., Hanauer, M. X., Lohre, H., & Blitz, D. (2024). Factor Zoo (.zip). The Journal of Portfolio Management, Quantitative Special Issue 2024, 50(3), 11-31.
2 Harvesting short-term alpha factors brings some challenges and Blitz et al. (2024) allude to how these can be tackled in practice.
3 Blitz, D., 2024, “The unique alpha of Robeco Quant Equity strategies”. Robeco client note
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