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Money is moving toward smart beta

The popularity of factor investing is growing, but is it a long-term story?

Every year for the past six years FTSE Russell has surveyed asset owners about their views on smart beta. The findings reveal just how much these strategies have gained in popularity in a very short time.

In 2015, 28% of respondents were using smart beta in their portfolios. This year, the number had grown to 58%.

Read: Smart beta is getting even smarter

“Money is moving in this direction,” Peter Weidner, head of factor solutions at Wells Fargo Asset Management, told the Satrix conference in Cape Town this week. “And it’s moving at an accelerated pace.”

The attraction

What is telling is that this is not just because of the low cost appeal of smart beta or factor funds. Although 31% of respondents in the 2019 survey have adopted smart beta to reduce their costs, there are other, more important considerations.

“They want to generate additional return, reduce their risk and improve their diversification,” Weidner noted. “Cost is a consideration, but it’s not the primary one.”

The reason asset owners are increasingly turning to smart beta to achieve these objectives is because it is transparent, efficient and consistent.

Since it is rules-based, portfolio managers know that they are getting exposure to exactly the market factors they are looking for.

These are the factors – value, momentum, size (small cap), low volatility and quality – that have proven over time to deliver a premium return to the market. While their performance has varied over the short term, their long-term returns have been ahead of those of a broad market index.

Source: Analytic Investors & Satrix

The above is for illustrative purposes only. Pure factor portfolio as described in ‘Pure Factor Portfolios and Multivariate Regression Analysis’ by Roger Clarke, Harindra de Silva, and Steven Thorley, Spring 2017 edition of the Journal of Portfolio Management studying the monthly returns and factor exposures on 1 000 large US stocks for the 50 years ending 2018.

“Over the last 50 years, we could have [received] more return from investing in any of these factors, and some of them would have helped reduce our volatility as well,” Weidner pointed out.

But what about the future?

One of the most important truths in investing however is that past performance should never be taken as a guarantee of future returns. Just because these factors have worked in the past does not mean they will continue to.

For Weidner, however, there are clear reasons why investors should have confidence that these factors will continue to deliver going forward.

“We think about the drivers of these factor returns in three ways – behavioural biases, structural constraints and risk compensation,” he said. “These are three things that I think can drive factor returns in the future.”

Markets are made up of people

Behavioural biases refer to the ways in which investors act in predictable ways in certain market conditions.

“Think of how this works for the momentum factor, where you are buying assets that have gone up in value and selling assets that have gone down in value,” Weidner said. “These trends tend to persist, and there is a human behaviour behind this. People follow the herd – they identify trends and extrapolate from there.”

The momentum factor has been one of the biggest drivers of market returns over the past few years as investors have shown a huge appetite for the large tech stocks around the world. As their prices have gone up, they have attracted more investment, and so the trend has continued.

The way things are

The second driver is structural constraints. These can be seen in the way the low volatility factor has been persistent.

In some ways this is counter-intuitive because if volatility is a measure of risk, investors should expect to be compensated more for taking more risk. Yet the low volatility factor has delivered superior returns at lower risk.

“There is actually a structural explanation for this,” Weidner argued. “If you think of the way the asset management industry is structured and incentivised – their portfolios are benchmarked against an index.”

In order to try to outperform that index in the shorter term, asset managers have to buy stocks that are more volatile than the market as a whole – known as high beta stocks.

“As a result low volatility stocks are often unloved, and ignored, which gives the opportunity for investors who are able to take that lower volatility to generate more return over time,” said Weidner. “So there is a structural reason why we think this will persist going forward.”

Risk and reward

The final driver is perhaps the most obvious, as it makes sense that taking more risk over time offers the potential for higher returns.

“Where we are able to bear some risk, for bearing that risk we should be rewarded,” Weidner said. “The small size factor is an interesting case of this. If you buy small companies you suffer from some illiquidity risk and you suffer from some information asymmetry.”

Historically, small cap indices have materially outperformed large caps, and this can be expected to persist. For the 25 years to January 2019, the S&P 500 had gained a total of 799%. Over the same period, the S&P 400 Mid-Cap Index was up 1 305%, and the S&P 600 Small-Cap Index 1 079%.

“I do like to understand what is driving these factors so that we can have a good belief in what will drive them going forward, rather than just looking at the past,” said Weidner.

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As an initial observation, the S&P500 makes up around 95% of the S&P1500 (which incorporates the ‘400’ and the ‘600’ mentioned above) so the investable opportunity in these smaller indices is modest.

But if you look at the first chart, where everything outperforms the market, surely the obvious question must be: what factors then underperform? Is it just the absence of these factors?

Also, if the factors that outperform are so well-established and identifiable, why do some 90%+ of US fund managers habitually underperform the market? Surely they would just avoid the stocks that lack any of these factors?

What we do know is that however you slice and dice the market, the average investor can only earn the average market return. If someone is buying momentum stocks, someone must be selling them. Why would they do that?

Perhaps what appears obvious with hindsight (and in studies like this) is far less obvious in the moment.

“If someone is buying momentum stocks, someone must be selling them. Why would they do that?”

Because, they’re cashing in? Sell high?

“Also, if the factors that outperform are so well-established and identifiable, why do some 90%+ of US fund managers habitually underperform the market? Surely they would just avoid the stocks that lack any of these factors?”

You’re assuming they pay attention to any factors. Most of them invest on fundamentals.

It all depends on period. By now trailing ten years avoids the 2007 to March 2009 mess and it is impact on standard deviation and return.

For a scary profile, plot Bookings and Apple and Microsoft returns and standard deviation. New category called Teflon

I haven’t even got my head around “impact investing” (or “social” investing….sounds rather like PAYE-tax to me?), and now there’s “factor” investing strategy.

Where does it leave the sons of Beta? Are they smart enough?

a Client recently asked me what I think of “Karatgold” Coin (KBC) (a crypto that’s apparently linked to gold & what not) is worth as an alternative investment? (You simply add the word scam to it, and many google reviews pop up from it being legit, to a scam to MLM). Possibly a #s**tcoin…

Excellent article. Easy to understand fairly complex issues!

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