Index Fund Management: A Practical Guide to Smart Beta, Factor Investing, and Risk Premia

258 Pages·2019·4.515 MB·English

by  Fadi Zaher

INDEX FUND
MANAGEMENT
A Practical Guide
to Smart Beta,
Factor Investing,
and Risk Premia
FA D I Z A H E R
Index Fund Management
“This is a wonderfully accessible and relevant book. Whether you are coming to the
subject for the first time or wanting an update on the latest thinking, Fadi’s book will
educate and entertain. His understanding of the importance of human behaviour
alongside financial theory is refreshing.”
—Sarah Aitken, Head of Distribution EMEA, Member of LGIM’s
Executive Team
“Comprehensive, insightful and immediately useful for investors! Fadi brings an
enormous wealth of knowledge and experience on both theory and practice to the
reader in an easy, accessible style. He provides a unique overview of the different types
of factors and alternative risk premia, their rationale and how to implement them
efficiently in a portfolio. This is the new reference book in this field, a must read for
all practitioners and people considering using factors and alternative risk premia in
their investment strategy.”
—Emiel van den Heiligenberg, Head of Asset Allocation at Legal & General
Investment Management
“The book is a great introduction into the world of factor investing and alternative
indexation. Accessible, yet very comprehensive. Read the book—and learn from one
of the best in the field.”
—Vitali Kalesnik PhD, Partner, Director of Research
for Europe at Research Affiliates
“The discussion of active and passive money management is needlessly polarised. This
timely book, written by a practitioner, explains clearly and comprehensively some of
the increasingly-popular strategies that might help investors find a middle way.”
—Kevin Gardiner, Former Chief Investment Officer (Europe),
Barclays Wealth & Investment Management
Fadi Zaher
Index Fund
Management
A Practical Guide to Smart Beta, Factor
Investing, and Risk Premia
Fadi Zaher
Index Solutions & Investment Specialists
London, UK
ISBN 978-3-030-19399-7 ISBN 978-3-030-19400-0 (eBook)
https://doi.org/10.1007/978-3-030-19400-0
© The Editor(s) (if applicable) and The Author(s), under exclusive licence to Springer Nature Switzerland AG
2019
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To Leila, Jamil and Rose
Acknowledgements
The seeds of this book were planted few years ago, during my time at Barclays
Wealth and Investment Management and grew along the journey at Kleinwort
Benson and Legal & General Investment Management (LGIM). I benefited
intellectually and practically from discussion with colleagues, clients and
friends on financial markets and factor investing. Today, factor investing is
among the fastest growing areas in the financial industry, and this book aims
to bring a consolidated views and central debates on the topic from a profes-
sional and academic points of view.
I owe many people for the discussions and feedback on the topic over the
years. I would like to express my gratitude to colleagues and friends (in
approximate chronological order): Anup Prasad, Dayu Ren, Helene Oger-
Zaher, Keyvan Andersson, Dominik Bekkewold, Carlos Andersson, Kevin
Gardiner, William Hobbs, Amie Stow, Petr Krpata, Tanya Joyce, Greg
B. Davies, Christian Theis, Wei Yang, Aaron Gurwitz, Michael Dicks, Einar
Holstad, Mark Cooke, David Head, Ying Xu, Thomas Fekete, Adrian Biesty,
Anthony Skitini, Michael Rath, Mouhammed Choukeir, Mohamed Ellouze,
Alexander Mirtchev, Delyth Richards, Gene Salerno, Andrew Thompson,
Fahad Kamal, Geoffrey Boullanger, Daria Kuzina, Karl Sawaya, Denis Nagy,
Roman Joukovski, Mike Bayley, Emiel van den Heiligenberg, John Roe, Chad
Rakvin, Colm O’Brien, David Barron, Greg Behar, Aniket Das, Shaun
Murphy, Aaron Meder, Adam Willis, Aimee Bowkett, Roger Bartley, Anna
Walsh, Anne-Marie Morris, Dan Attwood, David Chapman, Howie Li,
Joseph Firth, Lee Collins, Nelson Nery, Sebastien Monfort, Tasos Kontos,
Ciera Radia, Mathew Webb, Mehdi Guissi, Graham Moles, Paul So, Sarah
Peasey, Panagiotis Berdos, Silvio Corgiat Mecio, Simon Hynes, Max Julius,
Eliza Grimond, Lucy Johnstone, Johannes Davis, Vitali Kalesnik, Christina
vii
viii Acknowledgements
Alexi, Jennifer Steding, Amjed Younis, Timo Pfeiffer, and many members of
LGIM’s Index and Multi-Asset teams.
Special thanks to Joseph Johnson and Tula Weis at Palgrave Macmillan,
Andrzej Pioch, Daria Kuzina, Kevin Gardiner, Vitali Kalesnik, Wei Yang,
David Barron, Julia Alpar and James Zucker for reading the manuscript and
for their reviews and valuable input. All views expressed in this book are mine.
Peer reviewers, colleagues and various employers are not responsible for the
views or the content.
Lastly, I would like to extend my appreciations to Kenneth R. French,
Solactive, Bloomberg and others for permission to use their data to construct
many of the examples in the book.
Contents
1 Introduction: What We Talk About in Factor Investing 1
Part I E volution of Factor Investing and Index Fund Management 7
2 Stepping Up to Factor Investing 9
2.1 H istory of Significant Advances in Indices and Indexed
Funds 12
2.2 G rowth and Adaptation of Factor Strategies 14
2.3 Th e Taxonomy of Risks and Returns 16
2.4 F actor Investing Versus Traditional Index and Active
Fund Management 18
2.5 Th e Misconception of Factor Investing in the Press 19
2.6 Consideration When Looking at Factor Investing 20
2.7 C oncluding Remarks 21
3 Architecture and Art of Indexation 23
3.1 Why Index Architecture Matters 24
3.2 Representativeness of the Index Strategy 26
3.3 Modularity of an Index 27
3.4 Availability: The Amount of Stocks and Bonds
Outstanding 29
3.5 Stock and Bond Weightings 30
3.5.1 M arket Value Weighting 32
3.5.2 E qual Weighting 33
ix
x Contents
3.5.3 P rice Weighting 34
3.5.4 O utcome-Oriented Weighting: Tilting and
Optimisation 34
3.6 I ndex Maintenance and Operations 35
3.7 R eplication and Management of Index Funds 37
3.7.1 T rading Strategies 38
3.7.2 S ecurities Lending 39
3.7.3 C ash Management 40
3.8 C rowding Risk of Index Funds 40
3.9 Th e Capacity of Index Funds 42
3.10 C oncluding Remarks 43
Part II Equity Factor Investing 45
4 Equity Factor Investing: Value Stocks 47
4.1 S chools of Value Investing 49
4.2 Th e Value and Growth Debate 51
4.3 I ntrinsic Value 54
4.4 S ystematic Screening Approaches 56
4.4.1 Benjamin Graham Screen 58
4.4.2 Price-to-Book (P/B) Screen 60
4.4.3 Price-to-Earnings (P/E) Screen 62
4.4.4 Price-to-Sales (P/S) Ratio 64
4.4.5 Comparison and Combination of Screens 65
4.4.6 What Constitutes Good Screen Criteria? 68
4.5 B ehavioural Drivers of Value Factor 69
4.6 Market Structure and Reward for Risk 71
4.7 C onsiderations for Value Investing 72
4.8 C oncluding Remarks 74
5 Equity Factor Investing: Quality 77
5.1 I nvestment Horizon for Quality 79
5.2 Q uality Factor Screens 80
5.2.1 Profitability Screen 81
5.2.2 Asset Growth and Investment Screen 83
5.2.3 L everage Screen 85
5.2.4 E arning Accruals Screen 87
5.2.5 C orporate Governance Screen 88
5.2.6 Combined Quality Screens Among Practitioners 90
Contents xi
5.3 D rivers of the Quality Premium 93
5.4 Q uality and Valuation of Stocks 95
5.5 C onsideration for Quality Strategies 96
5.6 C oncluding Remarks 98
6 Equity Factor Investing: Low Risk 99
6.1 W hy Considering Low Volatility Factor Investing? 101
6.2 L ow Risk Factor Approaches and Construction 102
6.3 C ommon Low Volatility Factor Indices 105
6.4 B ehavioural Drivers of the Factor Premium 107
6.5 M arket Structures Driving the Factor Premium 109
6.6 C onsiderations When Implementing Low Volatility
Strategies 110
6.7 L ow Volatility in Asset Allocation 114
6.8 C oncluding Remarks 115
7 Equity Factor Investing: Momentum 117
7.1 E volution of Momentum Investing 118
7.2 R ules-Based Momentum Index Strategies 121
7.2.1 Cross-sectional Momentum Strategies 121
7.2.2 Time Series Momentum Strategies 123
7.3 M arket-Based Index Strategies 125
7.4 B ehavioural Drivers of Momentum Premium 127
7.4.1 H erding Behaviour 127
7.4.2 R epresentativeness and Confirmation Bias 129
7.5 Th e Reward for Risk and Market Structures 130
7.6 Consideration for Momentum Strategies 132
7.7 Concluding Remarks 133
8 Equity Factor Investing: Size 135
8.1 D efining the Size Factor 137
8.2 C onstruction of Size-Based Index Strategy 138
8.3 Th e Existence of the Size Premium 139
8.4 R isk-Based Explanation of the Size Premium 141
8.5 N on-Risk Based Explanation 142
8.5.1 The January Effect 143
8.5.2 Inefficient Pricing 143
8.5.3 Attention, Coverage and Transparency 144
8.5.4 B ehavioural Drivers of the Size Factor 145