Are Factor Investing and Smart Beta Identical? | Nicolas Rabener – Factor Research

Factor Investing has become more
popular over time, especially since the financial crisis
simply because investors realized that there is actually very little Alpha and most of it is just called systematic beta or factor exposure. Of
course investors do want to achieve outperformance so if you're benchmarked
against that S&P500. and the S&P500 is up ten percent
it would be great if you have eleven percent. Now finding fund managers that
generate that extra 1% that you want… that's actually quite challenging.
Factors have shown over the long term, especially if you combine several
factors, that they do allow to outperform an index and that's why they
have increased in popularity. They're the only source of returns that do allow to
outperform the index. It doesn't matter which asset class. One way of explaining
why factors work why they should generate excess returns is that they do
represent risks. And you get effectively compensated for holding them, once
in a while the risk actually takes place there's a drawndwn but over a long time you
can harvest those returns. Factor investing comes from the academic world versus
smart beta is a practical application. Smart beta is nothing than factor
investing in a long only form. So effectively what companies like Blackrock or Vanguard do is: take the S&P 500 and tilt it towards
certain factors. Someone wants to take advantage of the value factor? They can
look for a 'Smart Beta Value ETF'. It's very important to note that there's
a big discrepancy between theory and reality. So what most investors who are
interested in factor investing do is: they tend to read academic research or at least
read what other people are summarizing about the research. What you see is
those returns being published in journals and for example the value factor
giving XYZ present return. Now what unfortunately has happened is that you take the
investment products that most investors have access to, such as retail investors in smart beta ETFs. The returns they get out of those are often a fraction of what you see in academic journals so it's a big disconnect between what people are
reading and what people are getting and that's something worth highlighting. The
opportunity set that investors have especially on the retail side is just
so much more narrow than what you have on the institutional side, where you can
replicate structures that are more similar to what you read in academic

Should You Be Factor Investing?

Factor investing is currently one of the hottest
terms used to sell financial products. You may have also heard the term smart beta,
which is referring to the same concept. A simple way to think about factors is that
they are quantitative characteristics shared across a set of securities. The reason that we care about factors is that
those characteristics can be used to structure an investment portfolio to outperform the
market without the need to rely on stock picking or market timing. Factors are on the cutting edge of financial
market research, but they are also being used to market products that may be detrimental
to investors. Don't get me wrong, factors are more than
a sales pitch. They are the mechanisms that drive asset returns. I'm Ben Felix, Associate Portfolio Manager
at PWL Capital. In this episode of Common Sense Investing,
I'm going to tell you about factor investing. Before we understood factors, researchers
were noticing that diversified portfolios of small stocks were outperforming diversified
portfolios of larger stocks. At the time there was no explanation for this
difference, and the performance difference may have been attributed to the skill of the
portfolio manager. As factor research emerged, it became clear
that stocks with certain characteristics could explain a lot of the differences in returns
of diversified portfolios. The reason that we care about factors is that
those performance differences have been positive. Capturing positive return differences exhibited
by certain types of stocks has an obvious benefit to investors. Currently, factor models explain over 95%
of the return differences between diversified portfolios. This is problematic for active fund managers
because their ability to beat the market, which was previously assumed to be due to
their skill, can in many cases be explained by factor exposure. This is a big deal for investors because if
you can get market beating returns with a factor index fund as opposed to an active
manager you will save a lot on fees. Here is a concrete example to explain what
I mean. In a classic 2015 blog post, my PWL colleague
Justin Bender took a handful of actively managed market-beating mutual funds suggested by Globe
and Mail columnist Rob Carrick and performed a three-factor regression. In other words, he used some analysis to show
how much of their performance could be attributed to factor exposure as opposed to manager skill. In most cases the outperformance was fully
explained by factor exposure, and in one case it was mostly explained. This means that while these active funds did
beat the market, they did so by holding more small cap and value stocks than the market,
not by skillfully picking the right stocks at the right time. Holding more small cap and value stocks than
the market is something that an index investor can replicate at a fraction of the cost of
an actively managed fund. Research on factors emerged in the 1992 paper
by Eugene Fama and Ken French titled The Cross-Section of Expected Stock Returns. In the paper, they observe that small stocks
outperformed large stocks over time, and value stocks outperformed growth stocks over time. The explanation for the return differences
is that stocks with these characteristics, small stocks and value stocks, are riskier. Investors must expect higher returns to own
riskier assets. In 1997, Mark Carhart added the momentum factor
to the body of research, and later, in 2012 Robert Novy-Marx added the profitability factor. This gave us five factors which together explain
over 95% of the return differences between diversified portfolios. Fama and French came out with their five-factor
model in 2014, combining market, size, relative price, profitability, and investment, while
ignoring momentum. The ultimate factor model is unknown, but
researchers continue to test new factor models to increase the explanatory power of the model. Factor research has become not only important
to our understanding of finance and investing, but a way for academic researchers to make
a name for themselves. After all, Fama was awarded the Nobel Memorial
Prize in Economic Sciences in 2013 for his work on asset pricing. This academic competition for discovery of
the next factor has resulted in many, many research papers being published claiming to
have identified new factors. Duke University's Campbell Harvey, Texas A&M's
Yan Liu, and University of Oklahoma's Heqing Zhu have identified over 300 factors in academic
literature. This is problematic for investors. Targeting five factors in a portfolio is hard
enough. What do you do if there are 300 of them? Unfortunately for the researchers, and fortunately
for investors, many of these factors do not pan out. In many cases they turn out to be a re-packaging
of the original factors. There is a sniff-test for investors to know
when a factor is worth pursuing, and when it should be ignored. To be taken seriously a factor should be persistent,
pervasive, robust to alternative specifications, investable, and sensible. It is worth digging into each of these characteristics. For a factor to be persistent it must show
up through time and not be limited to a specific time period. To be pervasive a factor must hold true across
various countries, regions, and sectors. Robust to alternative specifications means
that the factor should not be affected if you slightly change how the characteristic
is defined. Investable is extremely important – it means
that if the factor cannot be cost-effectively captured in portfolios it is not helpful to
investors. Momentum is an example of this. The momentum factor meets many of the previous
characteristics, but it is a high-turnover strategy. This makes it expensive to implement in a
portfolio. If there is no sensible explanation for a
factor, then it may not be expected to persist. Again, momentum is an example. Unlike the risk explanation for small and
value stocks, momentum does not have a sensible explanation. While many factor products have emerged, there
are very few companies creating factor products that get me excited. One company that has done and continues to
do an excellent job in this space is Dimensional Fund Advisors. The research on factors is a commodity – anyone
can access it. The difference between implementing factors
well and poorly comes down to how the company vets the factor research, who does the vetting,
how they interpret the data, and their ability to understand of the limitation of factor
models. The founder of Dimensional Fund Advisors,
David Booth, has said "The research is out there for anybody to access. What distinguishes Dimensional is the way
we implement the ideas." While I do believe that a factor portfolio
is optimal, Dimensional Fund Advisors' products can only be accessed through specific firms,
like PWL Capital. Based on this, and with a lack of ETFs, especially
in Canada, that are effectively capturing well-researched factors at a reasonable cost,
I think that DIY investors are probably better off, at least for now, focusing on simplicity
rather than pursuing factors. The Canadian Couch Potato model portfolios
used to pursue the size and value factors, but Dan changed the models in 2015 to ignore
factors entirely. Part of his explanation was that "many DIYers
make costly mistakes when they try to juggle too many funds. Meanwhile, there are exactly zero investors
in the universe who failed to meet their financial goals because they did not hold global REITs
or small-cap value stocks." I agree with him in full. Have you tried to implement a factor portfolio? Tell me how it went in the comments. Thanks for watching. My name is Ben Felix of PWL Capital and this
is Common Sense Investing. I will be talking about a new common sense
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