Leif Cussen, manager of the Old Mutual Style Premia Absolute Return Fund, outlines four elements crucial to the selection of factors that can be harnessed to build systematic, liquid and well-diversified strategies.
Factor investing, whereby the fundamental and technical drivers of securities are used to create diversifying strategies, has in recent years become democratised: it is now accessible to investors beyond those willing and able to pay hedge funds ‘two and twenty.’
Yet these generic factors – which we call ‘style premia,’ given they also refer to different investment styles – have proliferated in recent years.
In this piece, we describe our process for selecting from hundreds of potential candidates the style premia factors that can be harnessed to build systematic, liquid strategies – at the same time as being generally uncorrelated to each other and to major asset classes.
A basis in academic research is our starting point. Intuitively most investors could probably name a number of different factors that generate returns across different asset classes, but in order to create a robust, systematic strategy, we utilise the wealth of research conducted into these approaches over the last few decades.
As such, when examining a factor, we are looking for peer-reviewed research. But a foundation of academic research is not enough to give us confidence in persistent returns going forward. Indeed, a recent paper found over 300 factors with peer-reviewed, published research.
Just because one can brandish an academic paper about a factor does not mean it should be included in a portfolio. Given the risk of data-mining we would not necessarily expect all of these factors to deliver persistent returns over the coming years.