Building Funds By Module

April 07, 2014

In recent years a quiet revolution has taken place in the automotive industry. While continuing to produce cars under different brand names, manufacturers have focused on using common modules as the core components of each vehicle.

Open the bonnet of a typical front-wheel drive car from the VW group, for example—whether an Audi, Seat, Skoda or Golf—and you’ll find a single type of engine, crankshaft, clutch, ventilation and infotainment system. VW is extending its modular manufacturing platform, called MQB, even to its luxury marques like Porsche and Lamborghini.

The modular approach enables companies to cut costs and increase flexibility, while retaining distinct design elements for different brands. Modular manufacturing also helps companies avoid having to reinvent the whole production process when client demand changes.

Building block-based design is also common in several other economic sectors, including computer hardware, programming, power systems and high-rise buildings.

But in finance and investing, at least until a few years ago, complexity was not something to avoid: it was the name of the game.

Above all, the 2008/09 financial crisis was a story of overly complex products. They were sold by banks, whose senior executives didn’t understand the products, to investment firms, whose portfolio managers couldn’t value them.

The more opaque features a product designer could add on—options, hidden or disguised correlation and credit risks—the greater the profit margin and the higher the year-end bonus for the distributor.

Even the banks themselves have become “too complex to price”, Andrew Haldane, executive director of the Bank of England, said in 2012.

Things are beginning to change, however, and not just because regulators have started to crack down.

After a decade and a half of low returns from equity markets and in an environment of ultra-low bond yields, many investors are rethinking their approach to portfolio construction.

“In finance you still have a lot of actors and huge levels of complexity,” Jerome Morin, a structurer at investment bank Citi and formerly a nuclear physicist, told

“Previously there may not have been many external drivers to change the ways people were doing things, but since the financial crisis there’s been a big emphasis on cost reduction and efficiency. Look at the recent growth of low-cost operators in asset management. Portfolio performance is increasingly driven by macro factors and people are trying to identify them. There’s a big cultural shift going on.”

Morin points to the car business as a paragon of the building block approach that finance could emulate.

“The automotive industry is the most advanced in terms of the modularisation of processes,” said Morin.

“The idea is to split a system into its different parts and to try and reduce the interdependencies between those components. You then produce the components separately, using different subcontractors.”


David Blitz, head of quantitative equity research at asset manager Robeco, told that the financial crisis and investor disappointment with the performance of active managers has also driven the search for alternative portfolio construction approaches.

“The traditional approach of building investment portfolios by asset class, for example equities, investment grade and high yield bonds, private equity, hedge funds and commodities, was questioned after the financial crisis, when we saw that the diversification benefits were not as great as expected,” said Blitz.

“Now people are focusing more on factor exposures. There’s a lot of evidence showing that factor returns are persistent and a long-term phenomenon. And if you think in terms of factors, then the traditional asset class boundaries are not that relevant anymore.”

Factor investing in equities often focuses on capturing value, momentum, low volatility and other risk premia, while systematic approaches have been developed to isolate and capture factor returns in other asset classes like fixed income, currency and commodities.

“Another catalyst for the factor-based approach was the analysis undertaken by the Norwegian government into the returns of the active managers managing its pension fund,” said Blitz.

“They discovered that a lot of the returns were less due to individual manager skill than the result of a handful of factor exposures. The question is then whether you can get more efficient exposure to these factors than by employing expensive active managers.”

A key question for those advocating a modular, factor-based approach to investing is who should produce the individual sub-components. Index firms, asset managers and investment banks all offer competing versions of popular systematic strategies.

For Robeco’s Blitz, index firms and quantitative asset managers may play complementary roles.

“The index firms provide factor or so-called ‘smart beta’ solutions in a transparent, rules-based way and at low cost,” said Blitz.

“Although these solutions are good, they are designed primarily for simplicity and appeal and they may not be optimal. An asset manager may be able to offer factor exposure in a more efficient way but this comes at a slightly higher cost.”

There’s also a role for the truly active manager, said the Robeco executive, but managers’ performance will be scrutinised more closely than before.

“There will still be room for true active manager skill, but the bar is raised since it has to be real skill, not something you can easily repackage as alternative beta,” said Blitz.

In a modular investment world the role of banks will be refocused on the provision of liquidity, said Citi’s Morin.

“The role of investment banks will be to enable trade execution and to provide the liquidity for large-scale transactions in baskets of securities. But the banks will also be users of the factor building blocks for hedging and arbitraging,” said Morin.


The European chief investment officer at Vanguard, one of the major beneficiaries of the post-crisis trend towards low-cost investing, sounded a note of caution about modular investment approaches.

“When you deviate from the broad market, whether to express some insight you believe you have, or to reduce a certain type of risk, make sure you do it consciously,” Jeffrey Molitor told

“Different strategies will work at different points in time but to date nothing has been shown to be a perpetual alpha machine. One of the reasons to be wary is that investors may have good reasons for entering a strategy, but when it starts lagging they jump out. Having discipline is important. The same applies when selecting active managers, all of whom have bad runs from time to time.”

Robeco’s Blitz concedes that a switch from traditional asset allocation methods places extra responsibility on those charged with the oversight of portfolios.

“The performance of different factors is cyclical and if you start out by investing in just one factor—value, for example—you may be tempted to sell out if the short-term performance fails to match your expectation. Factor investing is also more complex and so a greater burden is placed on the boards of trustees at pension funds, not all of whom may be investment experts,” said Blitz.

Baer Pettit, chief executive at index provider MSCI, told that a move away from using the market portfolio for benchmarking or investment purposes means checking that the building blocks you use are viable.

One of the chief concerns of the designers of modular manufacturing processes is to try and ensure that individual components do not depend on others for their performance or stability.

“Various attributes of markets can be modularised and understood in a systematic way,” said Pettit.

“A key question is whether those segmentations are clear and stable over time. The capitalisation-weighted market portfolio is transparent and macro-consistent, so when you deviate from it there may be degrees of ambiguity in the approach.”

Agreeing common factor-based approaches to investment would help address concerns about stability by increasing transparency and competition, said Citi’s Morin.

“What would give a major boost to the risk premia-based approach would be to standardise the factor indices in the same way as country and industry classifications have largely been standardised,” said Morin.

“It’s more difficult to standardise factor indices as they face greater liquidity constraints than market indices,” Morin conceded.

“And at the moment all the providers of factor approaches are trying to push their own versions. But if the biggest asset managers, who are all driven by cost considerations, pushed their suppliers to standardise factor approaches then this type of investing would take off quickly.”

Even if the building blocks of a modular portfolio approach remain non-uniform and somewhat rough at the edges, the factor investing trend seems to be taking off.

“Factor-based approaches are new tools that give people more control and more flexibility in the management of their portfolios,” said MSCI’s Pettit.

“Day by day we’re seeing billions of dollars come into these strategies.”


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