The so-called “smart beta” wave has been sweeping across the investment world with myriad thought pieces, opinions, and product launches in recent years. As 20-year managers of factor-based strategies, we have worked with hundreds of clients and this experience informs our observations of this investment style – including its benefits and pitfalls.
Our conversations with our clients have changed over the past few years. Several years ago, many saw factor-based investing as an evolution of “quant” and viewed it as a way to beat the benchmark for a small part of their overall investment plan; some saw it as a satellite strategy. Others found interesting academically, especially given the proliferation of strategies and the arrival of “smart beta” managers. But it seems our clients’ thinking has evolved in a new way. They increasingly are asking us how to use equity factors in the core of their portfolios, as a strategic tilt to align with their liabilities. As such, this investment approach appears to be moving from niche, or curiosity, to a major force in improving outcomes. As such, the conversation is not “what” or “why,” but has decidedly moved into the “how” stage.
Unfortunately, confusion is still high due to the proliferation of so-called “smart beta” products, many of which are the unfortunate result of data mining. These strategies often capture uncompensated risks or obtain factor exposures indirectly through haphazard weighting schemes. Therefore, we see “smart beta” as a catch-all term; but we encourage our clients to focus on pure factor-based approaches where the level of compensated risks are high compared to uncompensated risks. In an effort to help provide clarity on this issue, we developed a measure called the “factor efficiency ratio” and wrote a paper introducing it here. Investors should also ensure the efficiency of their factor strategies is high, otherwise they risk degrading information ratios and eventually outcomes, which we demonstrated our paper “Improving Risk Budgeting.”
The main advantage of a factor-based strategy is that it has more persistence than traditional active managers. We discussed this in our paper, “Improving Active Risk Budgeting,”and it is the topic of several academic papers (e.g. Carhart1) that show active management delivers return via risk factors, and that idiosyncratic risk has generally detracted from results. If you believe you can replicate the factor exposures of active management in a more persistent fashion, then the case for a large allocation of factor strategies becomes clear because consistency, cost, and liquidity all improve in this paradigm.
When speaking with our clients, we also hear a common refrain that we believe is in keeping with our research: their satellite manager allocations have blended together to form a complex (and expensive) index fund or slight factor tilt that could have been replicated more efficiently. This realization is driving a high degree of interest in factor-based strategies. However, we caution investors to avoid making the same mistakes they have made with satellite managers. This is because factors behave in rather predictable cycles, most notably in their length. For example, high return factors such as value have longer cycles of 4 to 5 years, whereas the more muted factors such as low volatility are shorter in length at around one year. However, the measurement of a manager’s performance is typically done over rolling 3 to 5 year periods. This means a value investor could make the same mistake as one in a concentrated strategy if they give in too soon and liquidate right at the bottom of the cycle. This pattern of investor behavior is captured empirically in the Goyal and Wahal study2 that showed underperformance after a manager is hired and outperformance after they are fired. This is why understanding factor cycles is necessary to ensure your performance review cycles align appropriately.
Being aware of the equity factors cycles is essential, as one must be cognizant of the sustained periods of underperformance that occur. In addition to being aware of the factor cycle length, we also advise clients to pair their factor strategies with an attenuating factor. For that purpose, we have developed a “quality” factor that enhances the risk/return trade off of raw factors and mitigates factor cycles. We wrote about it here.
Now, as investors migrate their portfolios toward factor-based investing, here are some practical observations:
- Improved Outcomes - Factor-based strategies can meaningfully improve outcomes – if you have the patience to evaluate them over long-term time horizons.
- Unintended Allocation Weightings - Many “smart beta” products are the result of data mining and often gain factor exposures indirectly through haphazard weighting schemes.
- Strategy Matters - Be intentional and strategic about your factor exposures and line them up with your evaluation horizon, otherwise risk the chance of buying high and selling low.
- Preparation is Key - Be prepared for drawdowns with factor investing and try to mitigate these occurrences by pairing risky factors with an uncorrelated quality factor.
- Managers - Pick factors not managers
A factor-based program can vastly simplify investment consistency, cost, and transparency, not to mention outcomes, if used strategically in the core of your portfolio.
1Mark M. Carhart. “On Persistence in Mutual Fund Performance,” Journal of Finance, Vol. 52: 57–82, 1997.
2Goyal, A. and Wahal, S., “The Selection and Termination of Investment Managers by Plan Sponsors,” Journal of Finance 63(4) 1805‒1847, 2008
Do you want to know more?
- The impurity of smart beta product
- Not just which factor, but when
- Pick factors not managers