By Vanguard :
Advisors are interested in using factors. But it takes a lot of due diligence to choose among the many products and implement them in portfolios.
The 2017 Cerulli survey of ETF usage shows that advisors are interested in factor-based (also known as strategic beta) products and expect to increase client allocations to the category in the coming two years. But choosing particular ETFs or conventional mutual funds to use among the hundreds available can prove daunting.
If an advisor decides that factor-based investing is the right choice for client portfolios, the advisor will need to answer three major questions before selecting the factor products, said Doug Grim of Vanguard Investment Strategy Group and coauthor of the white paper Equity factor-based investing: A practitioner's guide . 1
Those questions are:
- What is the most appropriate securities weighting method?
- Should the factor-based strategy be structured as a rules-based passive or active vehicle?
- If multiple factors could help achieve a client's goals, how should they be combined?
"A lot of marketing highlights the long-term performance of particular factors or strategies.
But the reality is that the performance of any factor-based product, as with other forms of active management, will likely vary over time and be difficult to predict," Grim said. "Just like a roller coaster, every factor strategy has its ups and downs. If you understand the nature of this cyclicality, you can better set your own and your clients' expectations, and that can help you make a better decision on how much of your clients' money, if any, you may want to commit to factors."
Before choosing factor products
Deciding how to implement factors assumes that an advisor has already decided which factor(s) may help the client achieve a certain goal (for example, enhance return or reduce risk).
There are three important criteria to consider when deciding whether to use one or more factors:
- Is there an enduring logical rationale for why the factor can be expected to persist in the future?
- Is there extensive empirical evidence that demonstrates the efficacy of the factor?
- Can the factor benefit the investor after all-in costs are considered (for example, taxes, expense ratio, bid-ask spread, and market impact)?
Security weighting
An important, yet often underappreciated, consideration when choosing a factor product, and an equity factor product, in particular, is how securities should be weighted, Grim said.
ETFs or conventional mutual funds that screen for particular factors and then weight securities by market capitalization provide a modest level of factor exposure and often have lower costs and turnover.
The alternatively weighted category is a catchall for any long-only technique that is not market cap-weighted. For those interested in factor exposure, it is often best to narrow their search to products that weight stocks based on the stocks' sensitivity to particular factors, such as relative price momentum or price-to-earnings ratios, because these products will provide higher and more consistent exposure to the targeted factor.
Long-short products often attempt to provide exposure to the desired style factor while attempting to reduce or eliminate sensitivity to movements in the overall equity market (i.e., market beta). Managers of these products buy those securities that are the most attractive based on favored metrics and sell short those securities that are the least attractive. Because short-selling is an expensive strategy that requires leverage, these types of products should be expected to incur additional costs.
"The answers to critical questions can help you determine which approach to take," Grim said. "Those might include: How much factor exposure do I want, and what is the right price (cost) to obtain it? Is the strategy expected to provide consistent exposure to the desired factor? Do I want to give up the potential equity risk premium (in the case of long-short)?"
Six common stock factor exposures
Source: Vanguard.
Passive or active?
While any type of equity factor tilt represents an active decision, tilts can be implemented using index or active vehicles. Index versions offer high transparency, typically have lower costs, and are driven by the underlying methodology documented by the index provider. In this case, the active decisions are largely included in the index design.
Active factor products fall into two categories: active selection and active implementation . Managers of products that employ active selection try to add value over and above the particular factor exposure by selecting securities they believe will perform better (in other words, they attempt to add alpha in addition to the factor exposure through either market-timing or supplemental stock selection).
Active implementation applies to managers who attempt to reduce trading costs and maintain more consistent factor exposure over time through trading flexibility around the rules based factor approach. For example, managers are permitted to rebalance when they observe a material decline in a factor exposure instead of being forced to reconstitute the portfolio only on predetermined dates, as many factor-weighted index approaches require. "These may seem nuanced but represent very important differences in the active management spectrum," Grim said.
The security-level weighting choice has numerous implications
Note: Points of differentiation in this table are considered relative.
Source: Vanguard.
Multifactor
The performance cyclicality of single factors leads some advisors to consider whether it makes sense to combine them. Offering exposure to multiple factors can provide potential diversification benefits and allow for simpler selection.
Advisors typically have two ways to provide multifactor exposure: either through assembling a collection of single-factor products themselves (a top-down approach) or by selecting a single product that targets stocks that look reasonably attractive when considering all the desired factors (a bottom-up approach).
The top-down method allows advisors to choose which factors to include, what weighting schemes to use, who the asset manager should be, and how much to allocate to each single factor product.
The bottom-up approach allows an asset manager, rather than an advisor, to select stocks after assessing their attractiveness relative to all the desired factors. Therefore, a stock with a moderate sensitivity to several of the preferred factors is more likely to be selected in a multifactor product than a stock that ranks highly in one factor screen but ranks poorly on all the others. This method may lead to less turnover versus a top-down approach, since stocks that no longer exhibit strong sensitivity to a single factor do not necessarily have to be sold if they still rank favorably with the other factor(s). This process also ensures that selected stocks are not inadvertently tilted against any of the targeted factors, potentially reducing or offsetting the benefit. Some research shows that the bottom up approach may lead to better long-term results for buy-and-hold investors. 2
A bottom-up, multifactor approach targets stocks that have multiple desired characteristics
Source: Vanguard.
No all-weather approach
What advisors should remember, Grim said, is that there is no ideal factor, or set of factors, that will perform well throughout all types of market environments. Some factors, such as value, may outperform for a time and then underperform. Others, such as low volatility, may offer some downside protection but lag during bull markets.
"Like a lot of styles in investing, there are caveats," Grim said. "It's very difficult to profit from factors by trying to time which will do better than others over short or intermediate periods. Results can vary widely among competing products, which is why due diligence is so critical. Costs, including taxes, can matter a lot. Make decisions based on net, not gross, expectations. Lastly, as in all investment matters, having clear goals and expectations, diversifying, watching costs, and maintaining discipline are essential to long-term investment success."
Footnotes
- Douglas M. Grim, Scott N. Pappas, Ravi G. Tolani, and Savas Kesidis, 2017. Equity factor-based investing: A practitioner's guide. Valley Forge, Pa.: The Vanguard Group.
- Jennifer Bender and Taie Wang, 2016. Can the whole be more than the sum of the parts? Bottom-up versus top-down multifactor portfolio construction. The Journal of Portfolio Management 42(5):39-50. (Special issue: Quantitative Equity Strategies.) and Roger Clarke, Harindra de Silva, and Steven Thorley, 2016. Fundamentals of efficient factor investing. Financial Analysts Journal 72(6): 9-26.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
