Tuesday, April 04, 2017

Equity Management #8 : Front-running and factor crowding.

If you follow this series on my blog, one of things you will realise is that it is increasingly harder and harder to come up with actionable ideas for readers as the equity management textbook becomes even more abstract. I was wading through 3 chapters on smart beta investing before I could compose this article. Nevertheless, this column is probably meant more for my own investment education than for the hapless reader.

Ok, back to equity management.

To assist in comprehending this short write-up, you can refer to Dr Wealth's excellent article on factor investing which I will share here. In summary : Factor investing basically means that you are very likely to outperform markets if you focus on low P/B, small companies, high momentum, high gross profitability and low volatility stocks.

Factor investing is ok for most intermediate investors, but something can go wrong if the finance industry gets into the same game and start pumping millions of dollars to the same stocks as intermediate retail investors. In the near future, we might be seeing the launch of smart beta ETFs which will allow investing novices to do factor investing by just buying a few counters on SGX.

This can result in factor crowding. If everyone dog piles into low P/B stocks, there are less profits for everyone else as prices of these stocks rise.

Another problem is front running which occurs when hedge funds become aware of the specific times when these smart beta ETFs rebalance their portfolios. They can drive up the low P/B stock counters just before these ETFs begin to accumulate those stocks which has the effect of lowering the return to these funds and anyone who is also trading those stocks at the same time.

So while it's great to do factor investing right now when the ETFs traded on the SGX are relatively primitive by US standards, things might start to change rapidly once our local finance companies start playing catch up by introducing newer products.

I also can't help noticing that my income portfolio is doing rather well lately as more Dividends and REITs based ETFs are being launched in SGX.


Alvin said...

Value investing has been around for 80 years but still works because most ppl cannot accept having trashy sounding stocks in their portfolio.

Factor crowding if it happens, would become a victim of their own successes. Their aum increases and that would result in not being able to capture certain factors properly, such as value and size in particular. They will end up like warren Buffett's too much money problem and have to invest in Low beta stocks and add leverage to boost returns. Value and size would still be retail investors playground

Christopher Ng Wai Chung said...

Good point, I doubt retail investors who do stock selection would be impacted as much as those to plough their cash into the smart beta ETFs.