Factor Investing Popular Among Institutional Investors

Institutional investors have taken an interest in factor investing, according to a study conducted by the Economist Intelligence Unit (EIU) and sponsored by BlackRock.

Factor investing is supported by years of academic research and is based on the premise that the risks and returns of all investments can be mapped to a common set of factors. Survey respondents believe macro-economic factors such as economic growth, inflation and interest rates, as well as style factors such as value, quality, momentum and volatility, 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. This strategy has become increasingly popular as a result of the financial crisis, when asset owners wanted to seek deeper insights into risks and returns, diversification and more efficient investment strategies, according to BlackRock’s report.

The survey found that more than 85% of respondents use factors in their investment process, and almost two-thirds of the institutions surveyed said they have 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 factor use over the next three years. When asked about their motivation for using factor investing, the most popular response was to better understand risk and return (76%). The same percentage said they had achieved this goal. More than half (59%) have achieved greater diversification, 56% have lowered risk, and 55% have increased returns.

“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,” says Mark McCombe, global head of BlackRock’s institutional client business. “This has resulted in a growing interest in factor strategies. Following an initial focus on risk management, investors increasingly believe that factor strategies can drive enhanced performance.”

NEXT: The most commonly used factors

BlackRock’s report also points out that the investment industry as a whole is yet to settle on a common definition for the term “factor,” and the type of factors used depends on the asset owners. Some investors, for example, may focus on macro factors such as economic growth while others cite inflation.

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

The idea of factors is to distill investments down into something very simple, as Ked Hogan, head of investments for BlackRock’s factor-based strategies group, points out. Implementing factor investing is more complicated, however. Investors must decide how to fund an allocation to factor-based strategies and where they believe these strategies should be in their portfolios, he adds.

Institutions are taking several steps to prepare for future factor use. More than two-thirds of those increasing factor use over the next three years will ensure they have appropriate risk management systems. More than half expect to seek advice from asset managers, and 37% expect to hire more staff. Half of those increasing factor use 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,” says 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.”

The global survey was conducted among 200 institutional investors representing $5.5 trillion in assets under management.

–Corie Hengst