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Is Factor Investing Active Management?

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The active-versus-passive investing debate has prompted exploration of “smart beta,” which moves away from traditional market capitalization in constructing allocations. Some advisors question whether the traditional approach still holds value.

A more appropriate consideration is to evaluate the client’s allocation needs, risk tolerance and investing goals, asking:

  • What is the best way to meet the client’s needs?
  • Which tools can most effectively do so?
  • How do those tools fit into the overall allocation model?
  • Do those tools carry unintended biases and risks that could compromise the portfolio?


TRADITIONAL BETA’S ADVANTAGES

Traditional beta provides:

  • a legacy representation of the overall market;
  • low tracking error to its respective market;
  • ease of maintenance and rebalancing;
  • ease of trading and reconstitution; and
  • greater product capacity.

Used correctly, factors can enhance risk management and diversification within a portfolio, offering opportunities to better enhance risk-adjusted returns than market-cap- weighted indices. Market-weighted approaches can work in tandem with factors to better achieve client goals.

WHERE DOES SMART BETA COME FROM?

Smart beta builds on William Sharpe’s capital asset pricing model (CAPM), where

                Expected return = risk-free rate + market beta * market premium.

This accounts for 70% – 75% of returns.

Eugene Fama and Ken French’s model considers three factors:

  • Volatility
  • Size – exposure to small-cap stocks, expressed as small minus big (SMB)
  • Value – high-value, or low price-to-book stocks, minus low-value or high price-to-book stocks. These also are called growth stocks and are expressed as high minus low (HML)

The three-factor model accounts for 90% of returns. That’s a big change from the traditional CAPM, which put managers’ alpha – their ability to beat the market – at 25% – 30%. Adding in the size risk premium and the value risk premium reduced managers’ alpha to 10%.

A fourth (Carhart) model added momentum, accounting for 95% of an investment’s return and reducing managers to just 5%.

Market-weighted products tend to be overweight in large-cap and growth names. Smart beta can potentially provide a neutral portfolio with market exposure as well as neutral exposure to other factors such as size and value. But smart beta has been reinterpreted to cover anything not market cap-weighted, which dilutes the true academic definition.

Instead of focusing on the label, it is more effective to understand the factors behind the concept. A lot of the most popular smart beta strategies take advantage of factors defined by academic research. Fundamentally weighted indices and dividend-weighted indices, for instance, both correspond to the value factor. Equally weighted indices offer exposure to size. Quality indices often focus on profitability. And 0–5-year bond indices manage exposure to term, a fixed-income factor.

Fund flows over the last several years reflect strong interest in nontraditionally weighted indices in the wake of post-crisis de-risking. Factor investing gives people a way to get incremental exposures in their portfolios. Factors also allow investors to increase diversification despite closer correlation of U.S., international and even emerging markets.

Investors looking solely at markets lose opportunities for diversification that factors provide. For instance, size can provide diversification if small caps in the United States are underperforming while they’re outperforming in emerging markets. Another point: factors must be viewed globally, not just in the United States.

HOW ETFS HELP

Technological advances, regulatory requirements and greater innovation have changed the active-versus-passive debate, with factor investing not necessarily being “active” in the sense in which it was formerly understood. Technology permits easier, more-efficient factor capture, allowing research, replication and application to real-world scenarios.

But factors can add unintended risk to a portfolio if they’re not reconciled with each other. Depending on how they’re captured, factors may or may not deliver the risk premiums sought. Traditional active management can inject idiosyncratic risk or stock-specific risk even as it seeks factor returns, while the best factor investing models take advantage of factors while eliminating idiosyncratic risk.

Nontraditional indices can provide:

  • a diversified exposure to mitigate idiosyncratic risk
  • the ability to harness compensated factors exposures
  • the potential to reduce biases to certain areas of the broad market
  • the capability to control exposure to certain risk factors

Multifactor investing explores how multiple factors perform together, can combine factors that provide diversification from one another and can improve the factor cycle. Adding factors that are negatively correlated with one another can smooth out the factor cycle, lessening investor risk and increasing incremental return over long time horizons.

For example, investors have a higher risk appetite during a risk-on period and put a higher premium on smaller-cap stocks, while during a risk-off period, there’s a flight to safety. Risk-on provides extra return from the size premium and a negative return from the value premium. But risk-off provides extra return from value and loses some on size. Over time, it balances out.

Another example is investing for quality alone. Top-quality companies carry a premium (are overvalued) and provide less excess return; companies with stronger performance are undervalued. Combining quality and value factors will select for high-quality companies that are undervalued.

FlexShares managers use flexible indexing to construct funds; objectives come first. Managers break investor goals into four quadrants: the need to grow assets, generate income, mitigate risk and manage liquidity. Before considering asset class, fixed income or equity, they consider how best to achieve each goal.

Investor needs are considered, the strategy is determined and the index is designed. To qualify, factors must persist over time, not exist as anomalies of a particular economic, regulatory or theoretical period. Factors that are not consistent through time and across markets; are not borne out by research or empirical evidence; and will not persist in the future do not maintain their efficacy. They are not valid.

We think that advisors considering factor investing should look at how the products work and ask questions about the process. A combination of traditional and factor investing, using the right factors, may work best to avoid risk and gain exposure for broader diversification and return.

— To learn more about this topic, watch the archived webcast, “Is Factor Investing Active Management?

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FOR FINANCIAL PROFESSIONAL USE ONLY.

Carefully consider the FlexShares Funds’ investment objectives, risk factors, charges and expenses before investing. This and other information can be found in the prospectus, which may be obtained by calling 1-855-353-9383 (1-855 FlexETF) or by visiting www.flexshares.com. Read the prospectus carefully before investing; investing involves risk, including possible loss of principal. Foreside Fund Services, LLC, distributor.

An investment in FlexShares is subject to investment risk, including the possible loss of principal amount invested. Fund returns may not match the return of its respective index. The Funds may invest in emerging and foreign markets, derivatives and concentrated sectors. In addition, the Funds may be subject to asset class risk, small cap stock risk, value investing risk, non-diversification risk, fluctuation of yield, income risk, interest rate/maturity risk, currency risk, passive investment risk, inflation protected security risk, market risk and manager risk. For a complete description of risks associated with each Fund, please refer to the prospectus.

 

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