Factor-based Smart Beta Strategy: Will National Pension Service Introduce Unvalidated Investment Strategy?

The National Pension Service (NPS) is planning to introduce a factor-based smart beta strategy in stock investment. The strategy has already received attention in the public offering fund market for foreign sovereign wealth funds and individual investors. However, some raise concerns over whether it is a proper investment strategy for the NPS that should pursue the safety over the profitability.

According to investment banking industry sources and National Pension Research Institute (NPRI) on August 15, the NPS is strongly considering a plan to allocate some of overseas stock investment assets into factor-based investing funds. Factor-based investing is an investment strategy in which securities are chosen based on past statistics of specific factors such as value and momentum. Among national pension and fund services, Teachers Pension and Police Mutual Aid Association adopted the strategy as an investment alternative that balances out the safety and profitability last year for the first time.

The NPS’ stock investment is divided largely by passive and active methods. The passive strategy is safe but it has a low profitability. The active strategy takes high costs but lower profits so since institutional investors which invest large funds in the long term have looked for alternatives. The NPS also came up with its own investment strategy based on factor-based investment results earlier this year.

Factor-based investing has been adopted by pension funds including Norway’s sovereign wealth fund. This is because it can be incorporated into some of stock investment assets or institutional investors can establish their own strategy based on past statistics. In the U.S. in where factor-based investment is made most actively, Blackrock and Vanguard Group aggressively launched funds and Goldman Sachs also released funds in 2015 for the first time.

According to a report titled “Factor-based Index Tactical Application Plan” released by the NPRI   last year, the U.S. stock market in the past saw its profits exceed when investing in the momentum sector and alternating investments in both the small and medium cap securities and large cap securities.

Some say that even the U.S., which is considered the country from which factor-based investment has originated, raise a question over the investment strategy that expects earnings rates in the future based on profits in the past. The factor-based investing has originated from the research results that the conventional investment theory, where the strongest investment strategy is to follow market capitalization which is naturally created by buyers and suppliers in the stock market, is statistically wrong. The U.S. has started research on it in the 1990s and there are still arguments. It is still an unproven theory. American Finance Association President Campbell R. Harvey, a professor of finance at Duke University, has openly pointed out problems in factor-based investing for several years. He said it was a biased theory in which researchers who cannot control various factors occurring in the market collected evidences that fit to their hypotheses. 

In this regard, Kwon Min-kyung, a researcher at the Korea Capital Market Institute, said, “Although there is a controversy over the effectiveness of factor-based investment, it shows a growing trend as the industry’s efforts to create differentiated products squared with investors’ to make excess earnings. Since factor-based investing doesn’t guarantee profits, the term “smart beta investment” in the asset management industry is inappropriate.”



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