Risk factors are here to stay: they are an efficient way to capture excess return, but understanding how they work and how they perform in different parts of the cycle is crucial, according to Gareth Parker (pictured), index product specialist and market development expert, during the Have factors succeeded smart beta? panel discussion at the 14th SRP Annual European Structured Products & Derivatives Conference on February 1 in London.

"If you look at structured products, banks are providing a huge number of products [linked to factor indices], which is not actually helping," said Parker. "When it comes to structured products, we need to simplify more and educate more."

However, even though there is a lot of talk about smart beta indices, they are rarely deployed in structured products, with many being used in exchange-traded funds (ETFs) instead, because it is very difficult to explain these strategies to investors, especially in the current regulatory environment, according to Mouha Ait El Ghachi, head of structuring French networks at Amundi Asset Management. "Maybe the way to sell smart beta strategies to investors to avoid this problem of regulation is to just sell the strategy separately," said El Ghachi.

Traditional factors are a measure to identify and explain outperformance, according to Matthias Lennkh, portfolio manager at Clear Alpha. "Sometimes, factors are understood as the outperformance itself," said Lennkh. "That being said, some factors are not investable. Factors such as GDP or inflation are not directly identifiable."

"The diversification perspective is very important," said Jan-Carl Plagge, head of applied research at Stoxx. "Some factor indices, specifically low volatility and minimum variance, are directly used in order to reduce the overall risk of the portfolio. Next to that, you have the perspective where we are not talking about factors for the purpose of diversification, but simply to capture the active premium that comes along for which the investor is rewarded," said Plagge.

There are periods in time when correlations have been important, even in times of market troubles, correlations have been going up and up, and the question is how we deal with it, according to Parker.

"We could see steep increases in correlation in those market neutral factors, premia especially, in 2007 and during the European debt crisis, but if you look at the levels of those correlations and compare them to correlations in for example market cap indices, they are still extremely low, they range from around 0.2/0.3 to 0.5," said Plagge.

Over time there has been outperformance down to factors, and "it is significant outperformance [...] however recently value has been doing worse and I don't know if there is a reason to believe that it's going to get better over the next few years", said Parker.

"In the last six months or so, we have seen a very big rebound in value which Rafi definitely has tilted towards," said Charles Aram, director, head Emea at Research Affiliates Global Advisors. "The Rafi Emerging Markets Index outperformed the MSCI market cap index by about 20%, which is a huge outperformance," said Aram. "We would expect to see that across the board with these various factors delivered out of strategies, I think you could see that with low volatility, I think you could see that with quality, with momentum.

"We think we definitely can time these smart beta type factors using valuation as a useful metric," said Aram. "You can take a number of company metrics, such as the price for sales, price of dividends, price of book, you can aggregate them and get some idea of how that factor is priced compared to its own history, not compared to the market in general but to its own history."

There has been a lot of discussion on a possible smart beta crash last year but he cannot see such an event happening, according to Lennkh. "I don't think so. Challenges are more regarding under performance," said Lennkh. "I would say patience and discipline is required by investors when it comes to factors, because they are very cyclical. What you can do is diversify and invest in multiple factors."

Some of these factors do appear quite robust over time, according to Aram. "Value seems to be robust and you can understand that," he said.

"There are problems with complexity, and curve fitting, backtesting, optimisation. Putting everything into a black box, while seemingly easy, is not helpful to the end investor," said Aram. "It is very helpful for the investor to understand what they own, so when there is a period of difficulty they can actually sit out that period," said Aram.

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