ERI Scientific Beta, a smart beta index provider and affiliate of EDHEC-Risk Institute, has jumped to the defence of factor-index investing in a strong rebuttal of a report published by investment consultants Mercer in November 2017 entitled ‘Factor Investing: From Theory to Practice.’

Noël Amenc, CEO of ERI Scientific Beta.

Factor investing refers to a strategy of investing which emphasizes exposure to certain risk premia which have been shown to be important in explaining historical risk and returns.

Popular factors include low volatility, value, low size, high yield, quality and momentum, and are increasingly being deployed within index-linked investment products such as ETFs.

The concept behind a passively managed factor ETF is that by shifting away from ‘plain vanilla’ market capitalisation-weighted indices one can, via a transparent, rules-based process, improve the risk/return profile without getting into expensive and time-consuming stock picking.

In Mercer’s report, the consulting firm not only underlines the usefulness of active investment management in the area of factor investing but also proclaimed its superiority by stressing the dangers of passive investment in this area.

[pullquote]The Mercer report is “representative of undocumented opinions on factor investing and as such is liable to misinform investors”, argues ERI Scientific Beta.[/pullquote]In ERI Scientific Beta’s view, however, the Mercer report is “representative of undocumented opinions on factor investing and as such is liable to misinform investors.”

Professor Noël Amenc, CEO of ERI Scientific Beta and co-author of the white paper issued in response to the Mercer report, commented: “ERI Scientific Beta was set up by EDHEC, a top-tier academic institution, to promote research and best practice in the area of smart beta and multi-factor investing. We felt that it was our responsibility to respond to a report that from our perspective runs counter to the above-mentioned objectives.”

Mercer’s first criticism of passive factor investing was to argue that factor strategies and factor indices are actually active approaches since all such strategies involve material deviations from the market cap index (in Mercer’s view, the only ‘truly’ passive approach).

ERI Scientific Beta countered by citing research indicating that market cap-weighted indices are actually poor proxies of the hypothetical market portfolio and tend to be highly exclusive and dynamic in respect of their constituents, thereby casting doubt on the notion of these indices being truly passive.

Systematic factor indices, by definition, do not require discretionary decisions (beyond those made to maintain the universe of their parent cap-weighted indices). ERI Scientific Beta notes that neither systematic nor discretionary strategy management guarantees success but the performance of the former can be more readily analysed and understood.

Mercer states that “truly unconstrained active strategies offer the potential to capture factor returns in an intelligent way, while also benefiting from market awareness and idiosyncratic alpha, potentially improving returns, controlling risk and enhancing diversification.”

While ERI Scientific Beta does not dispute this, it rejects the assumption that systematic approaches are incapable of delivering market-aware dynamic factor strategies that remain fully systematic and highly diversified. The EDHEC affiliate further adds that “the inability of active managers to produce alpha from stock picking and market timing in a robust manner is solidly established and casts grave doubts on the value added by manager selection (beyond that of organisational due diligence) in theory. The extant scientific evidence does not allow discretionary (a.k.a. active) management (or systematic strategies that embed significant market timing for that matter) to be recommended.”

At this point, Mercer steps up the heat in its report, going as far as to label factor indices “dangerous”, claiming their static design leads to the risk of crowding during rebalancing (especially when such strategies are offered in ETF format).

To counter, ERI Scientific Beta highlights its previous research that maintains there is little reason to be concerned about crowding if factor returns reward the taking of systematic risk. Indeed, it proposes that the risks of crowding and front-running are more significant with the “truly passive” approaches mentioned above than with properly designed factor indices.

In response to Mercer’s statement that factor strategies vary hugely and investors need to ensure that they have a full understanding of each strategy’s characteristics, pitfalls and expectations before investing, ERI Scientific Beta agrees that not all smart beta strategies are created equal but “only fully transparent systematic strategies can provide investors with the data required for in-depth quantitative diligence to measure the risks, costs and potential benefits of strategies and assess their suitability in the context of their risk and investment management needs and constraints.”

Finally, while Mercer states the importance of investors ensuring their portfolios are well-diversified by style factor (and it says active management is best suited to “fill the gaps” in this respect), ERI Scientific Beta affirms that “there is no disclosed basis that would make the case for the superiority of actively managed factor strategies in the context of completion portfolios.” Indeed, the systematic nature of factor indices make their factor characteristics more predictable when compared to active management, while building the majority of a core/satellite portfolio using systematic exposures will significantly reduce costs in portfolio construction.

Commenting on the disagreement, Stephen Thomas, Professor of Finance at the Cass Business School, said: “The rather amusing but heartfelt spat between two leading industry participants reveals at the very least the growing reach of smart beta and factor investing into the mainstream of institutional investing.

“Precious linguistic niceties underpin much of their dispute but one cannot escape the fact that either you believe in active investment or you do not: and no amount of clever maths and empirical modelling will change people’s deep-felt positions on this.

“The robustness or otherwise of multi-factor investment offerings, whether active or passive, will not be settled in our lifetimes – if indeed ever! – but that doesn’t mean that very clever researchers will not continually challenge and innovate in equal measure… Smart beta is alive and well!”