Factor-based investing has been given multiple labels. Morningstar's preferred term is strategic beta. Towers Watson, among others, calls it "smart beta." At Goldman Sachs, it's "active beta."
For my part, I prefer to describe these strategies as "targeted alpha." That's because they are based on specific factors, or attributes, that aim to accomplish one or two feats. One is to deliver on the risk premiums the factors in question have historically been shown to deliver compared to the broad market return. Secondly, these factors have often also served to reduce risk.
Whatever the label, factor-based investing has brought a new dimension to the debate over active versus passive strategies, the costs of investing, and the very notion of efficient markets. And once you've crossed that last bridge, discussion turns to the merit, validity and ultimately sustainability of factors identified as holding the promise of providing sources of superior risk-adjusted returns. What then remains is to identify the factor or combination of factors that are the right fit to meet an individual investor's needs.
First, let's identify the most important factors. Depending on how you define them, there are hundreds of factors employed by fund managers. Helpfully, the global indexing powerhouse MSCI Inc. has narrowed the list of key factors to six. MSCI's list is based on academic studies showing their ability over longer period to produce risk premiums:
Yield. These would be dividend stocks, whose dividend payments through time end up comprising a meaningful percentage of their total returns.
Volatility. Aimed at providing investors with exposure to reduced volatility, all the while enabling them to capture a meaningful percentage of the upside in favourable market conditions.
Quality. Focusing on companies with strong balance-sheet attributes and low variability in earnings.
Momentum. Premised on the notion that stocks enjoying operational momentum, as well as market-price momentum, tend to maintain these attributes.
Value. Buying equities at attractive prices in relation to fundamental valuation metrics, such as price to earnings, price to book and price to cash flow.
Size. Based on the notion that higher returns will reward those embracing the potentially higher risk associated with investing in smaller companies, which have the ability to generate higher growth rates but can be significantly more vulnerable than their larger competitors.
In Canada, yield has far and away been the most dominant factor in terms of the asset growth of factor-based strategies, followed by volatility-driven strategies. This shouldn't surprise anyone, in that yield-rich mandates appeal to investors starved for income generation, and reduced-volatility approaches help mitigate fears of future bear markets.
Perhaps for advisors and investors alike, the opportunity ahead resides in other factors -- value, momentum and quality. For instance, 2016 has seen a strong rebound for the value factor. Meanwhile, investors can consider whether the current setback for momentum investing is a temporary phenomenon, or possibly longer-lasting. Finally, with the expansion of factor-based ETFs, investors can obtain global exposure rather than only on a specific geographic basis. Also worth a look are factor-based mandates that employ multiple factors.
Here are other important considerations in choosing factor-based ETFs.
- Their performance can and will vary -- at times significantly -- from that of the broader market. At the same time, individual factors will produce vastly different results from one another.
- They are undeniably more expensive than traditional market-cap-weighted index strategies. Instead, consider them as directly competing against active mutual funds. Looked at in that way, their economics -- and anticipated effectiveness -- become more apparent.
- Certain factors may work better in one market than another. It is important to consider how the ETF you are considering is built, its capacity to deliver the results anticipated, and any challenges to that in the context of the market it draws on.
- Factor-based ETFs represent opportunities to seek a better match between investment objectives and risk tolerance, on one hand, and investors' preferences, biases, and the desired tilts they may wish to introduce in their portfolio construction.
- The holding periods should be mid- to longer-term, which ought to be fine if aligned properly with investors' preferences and objectives. An additional supportive element here is the ETFs' regular “refreshing,” as the screens serving to identify the equities meeting the desired criteria are reapplied in accordance with the parameters outlined at the launch of the product in question.
The bottom line: factor-based investing continues to grow at about twice the growth rate of the broader ETF industry. Properly understood and incorporated into portfolio construction, these strategies can bring added value and discipline to investors' portfolios. Variations in relative performance versus the broad market benchmarks should be understood, and will challenge investors' ability to stick to the discipline of the strategy.
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