Institutional investors are increasingly employing factor-based strategies across their investment process, a new study conducted by The Economist Intelligence Unit and sponsored by iShares parent BlackRock has revealed. Respondents believe factors, which investors can access via an ever-increasing number of exchange-traded funds, can help them deliver long-term outperformance, decrease overall portfolio risk, increase transparency in portfolio construction, and better understand past and future drivers of return.

Andy Tunningley, Head of Strategic Clients in BlackRock’s UK Institutional Business.

Supported by years of academic research, factor investing holds that the risks and returns of all investments, no matter how nominally diverse, can be mapped to a common set of underlying factors. The idea of factors is to distill investments into something very simple: macro-economic factors such as economic growth, inflation and interest rates, and style factors like value, quality, momentum and volatility.

The global survey was conducted among 200 organisations representing USD$5.5 trillion in assets under management and found factor use is widespread and on the rise. More than 85% of respondents utilise factors in some part of the investment process. Close to two-thirds of the institutions surveyed stated that they had increased their usage of factors over the past three years. The trend is expected to continue, with 60% of respondents indicating they plan to increase their use of factors over the next three years. The desire to improve returns is the most important motivation for increasing factor use.

“As is often the case, adversity has given rise to innovation. The unexpected correlations of asset performance during the financial crisis spurred investors to better understand underlying risks.  This has resulted in a growing interest in factor strategies,” said Andy Tunningley, Head of Strategic Clients in BlackRock’s UK Institutional Business. “Following an initial focus on risk management, investors increasingly believe that factor strategies can drive enhanced performance.”

For new factor users, a better understanding of risk exposures is the top motivation: more than three-quarters (76%) of factor users cited the desire for a better understanding of risk and return as a motivation, and the same percentage said they had achieved this goal. More than half (59%) have achieved greater diversification (the second most-cited motivation), and similar proportions have lowered risk (56%) and increased returns (55%).

Macro and style factors are employed in both risk management and investment strategies. More than half (53%) of the institutions surveyed use investment strategies targeting one or more factors with value being the most commonly targeted style factor and inflation being the most commonly used macro factor. Equity factor strategies (e.g. smart beta) are most widespread, used by 68% of investors, but more advanced long/short multi-asset strategies are also widely used, cited by 57% of those who invest in factors.

Institutions are taking a number of steps to support future factor use. More than two thirds of those increasing over the next three years will ensure they have appropriate risk management systems. More than half expect to seek advice from asset managers, while 37% expect to hire additional staff. Half of those increasing say they will make an initial allocation to an investment strategy to monitor performance.

“Having worked with several of the early adopters, seeing the increasing acceptance of factors by institutional investors is particularly gratifying,” said Andrew Ang, Head of Factor-Based Investing Strategies at BlackRock. “The research echoes my experiences with clients. The broad and growing number of institutional investors adopting factor-based investing reflects the benefits and versatility of the approach. Those reasons are why we are so confident in the outlook for factor investing.”