Dan Draper (pictured), Global Head of PowerShares by Invesco, describes factors as the building blocks of portfolios – the DNA of a portfolio's return stream.
For Draper, the origin of factor strategies lies in the mid-1950s and the ground breaking research from Professor Harry Markowitz, which led to the development of modern portfolio theory.
Draper believes that Markowitz's focus on diversification to reduce risk, combined with subsequent research by other economists, such as William F Sharpe, who developed the Sharpe ratio measure of risk and later helped develop the capital asset pricing model, all lie behind the development of factors.
Draper says factors can be thought of as quantifiable characteristics that can help explain the returns and risk of a portfolio. Among the more commonly used factors are low volatility, value, size, quality and momentum. But, says Draper, "The original factor is the market."
Early on, academics believed that markets were perfectly efficient and that asset prices fully reflected all available information. However, Draper says, increasingly, transaction costs, taxes and irrational behaviour tested the efficient-market hypothesis and the academics had to get to work again. Eventually, Stephen Ross produced the arbitrage pricing theory, which holds that an asset's returns are a function of many different risk factors. As computers became more efficient at handling analysis of data, a new range of academics could see a whole range of factors that could go into building a portfolio.
Draper says: "It's been over two decades now and much more research has been conducted – particularly as more data has become available and transaction costs have come down. That large body of behavioural finance research has underscored the cost advantages of exchange-traded funds. With ETFs, investors can gain access to risk factors previously available only through active management. And, increasingly, there are more factors in the tool kit which help investors find the best way to use the market to their advantage to diversify their portfolios."
Draper reports that demand for factor-based, smart beta ETFs is growing significantly as large asset owners, such as sovereign wealth funds or pensions, use low volatility, momentum and other factors within the cost- and tax-efficient ETF wrapper.
"Factor ETFs are seeing a growth rate of 2.5 to three times the growth rate of the entire ETF market," he says.
Asked whether it is better to access strategies through active or passive routes, Draper says it comes down to what investors want to achieve. "If you are trying to maintain a certain risk focus, then you might want to optimise the lowest-cost exposure. This would lend itself to a passive approach. But if you think there is the ability to generate outperformance, or alpha, then you can use an active approach," he says.
Driven by regulatory change in the US that has pushed advisers to charge fees and build discretionary portfolios for their retail clients, Draper believes that the market for smart beta ETFs will double from its current level of USD250-300 billion by 2020.
Adds Draper, "The transparency, liquidity, tax efficiency and low transactions costs of ETFs allow institutional and retail investors to potentially build better outcomes."