Edition: May/July 2018
Make active great again
A reflection on the rise of factor-based strategies by Jason Swar tz, head of portfolio solutions at Satrix.
As investors we’re all looking for the same thing: the best possible returns at the lowest possible risk and with minimal cost. Sound impossible? If we consider the rise of factor investing (or smart beta), this might not be that far-fetched.
If we look at the top performers in the General Equity category of unit trusts for 2017 (table 1 below), it appears that all the top performing equity funds were completely dominated by funds that are systematically run, i.e. their positioning is not determined by a traditional fund manager making fundamental calls, but rather by a disciplined rules-based approach selecting stocks to buy and sell based on a measurable investment characteristic.
This approach is known as factor investing. It embeds those same factors or characteristics that active managers exploit to deliver alpha, such as value, momentum, quality or size, but in the passive space these are implemented in a passive or rulesbased approach.
Factors are the fundamental building blocks of investment returns, and are measurable characteristics of listed stocks that may in some way explain future performance. We are able to measure many of these ‘factors’ and then test them to see whether they have any predictive power.
Why do factors work? They compensate investors for risk and exploit behavioural anomalies in the market. By tilting a portfolio to a factor (e.g. small caps) an investor expects to get a return above what the broad market (dominated by large caps) typically provides.
Importantly, our fundamental view is that these factors are fairly precise and intuitive drivers of risk and return in portfolios. Investors will ultimately benefit by viewing their portfolio through a holistic ‘factor lens’, and making investment decisions based on this approach. Understanding the different risk factors in your portfolio is critical, as it can lead to far better insights and more informed portfolio construction decisions.
And just like that, it sounds as if we’re slipping into the depths of a tiring ‘active vs. passive’ debate… meh. In some respects, perhaps. The debate I want to have is not whether the average active manager can consistently outperform broad equity benchmarks. They can’t, by the way. But have factor-based strategies (as represented by six out of the top ten performing General Equity funds in 2017) stuck their hands up as a legitimate investment proposition relative to traditional strategies?
Now, I’ll be the first to admit it. Any fund or strategy can end up being a top-performing fund over a short period such as a year. Furthermore, even if a specific strategy has outperformed its peer group or the market consistently over a period of time, the strategy is always susceptible to suffering periods of substantial underperformance under certain market conditions, due to their specific cyclicality.
What we typically advise clients is to blend different and uncorrelated factor strategies, as this produces more diversified portfolios. This mitigates the peculiarities associated with each individual factor.
But here’s what is interesting. If you look at this list of top-performing funds, they have no specific investment strategy in common. One would expect that over a particular period, a specific investment style would emerge as a clear winner. Last year, Quality, Momentum, and Dividend Yield featured as outperforming strategies, an almost unprecedented outcome.
Moreover, the top-performing funds were predominantly all factor-based (systematic, rules-based). It suggests that not only is this approach style agnostic, but that 2017 saw an almost universal failure of traditional managers to outperform across all investment styles.
This outcome advances the debate around active vs. passive (meh again), to one that frames the discussion around ‘traditional active vs. factor-based active’. If factor-based active strategies continue to illustrate their efficacy and ability to produce superior risk-adjusted outcomes, clients will benefit via improved transparency, capacity, predictability of returns, and importantly, lower fees (see chart below).
On the point of investment fees, it is interesting to observe that the top 20% of General Equity funds in 2017 averaged 0,82% management fees, and 1,15% of total expense ratios known as TER (see chart below), with poorer-performing groups of funds demanding high fee levels. Investment fees have certainly shown to be an arrow in the quiver of factor-based strategies. However, the primary motivation should not be low fees but to empower investors to build portfolios simply and efficiently.
Another constructive application of factor investing is performance benchmarking. An investor can now understand the value the active manager is adding beyond factor exposures, and particularly in relation to their fees charged, given that pure alpha is rare and more expensive.
While many fund managers explicitly avoid boxing themselves into a style box, it remains important for a manager who exhibits an investment philosophy relating to quality that that manager be measured against a quality factor-based strategy.
The rub here is that everyone’s definition of quality (or any other factor) is different. Ultimately one needs to lean toward providers with transparent, intuitive and academically grounded factor definitions. It provides a powerful way for investors to access tools for diversification, and also to unlock marketbeating returns.
This way, factor-based or otherwise, we can truly make active great again.