Factor and smart beta investing are “rapidly” displacing traditional stock picking, according to a new Research Affiliates paper.
“Traditional active management of equity mutual funds has delivered returns persistently below passive benchmarks,” says the paper by the Newport Beach, California-based firm, which specializes in smart beta. “In contrast, many factor-based smart beta strategies have persistently outperformed the same capitalization-weighted benchmarks.”
In the paper, “A Smoother Path to Outperformance with Multi-Factor Smart Beta Investing,” Chris Brightman, Vitali Kalesnik and Feifei Li of Research Affiliates examine how one can outperform the market with substantially lower relative risk by diversifying across simple smart beta strategies based on a half dozen robust factors.
“You can outperform the market by investing in factor-based smart beta strategies, and you can obtain this outperformance with a smoother ride — that is, with substantially lower tracking error and shorter periods of underperformance — when you invest in a diversified portfolio of smart betas,” the paper states.
1. Stick to These 6 Factors
Researchers have identified more than 300 distinct factors that purport to predict equity returns, and the number grows every year. Research Affiliates narrowed that number down to six factors that provide an opportunity to outperform the market.
“Our research leads us to conclude that only a handful of factors represent genuine future return opportunities — strategies with the potential to outperform in the decades ahead,” the paper states.
Those six factors that Research Affiliates identifies are value, profitability, investment, size, low beta and momentum.
All six factors demonstrate both statistically and practically significant returns.
The average annualized factor return in the United States over Research Affiliates’ study period (July 1973 to September 2016) was 4.86%.
“The prospect of an average annualized excess return of nearly 5% across six robust and largely independent factors helps explain the strong investor demand for factor investing,” the paper states.
Research Affiliates also finds that the correlations across these six factor returns are predominantly low or negative, which suggests they are independent and thus able to provide strong diversification benefits.
2. Diversify Across Factor-Based Strategies
To maximize risk-adjusted returns, Research Affiliates says to diversify across smart beta strategies that access the value, low beta, profitability, investment, momentum and size factors.
“Factor portfolios are impractical real-world investment strategies due to constraints on shorting and leverage,” the paper states.
Rather, Research Affiliates suggests applying its aforementioned factor research to create “simple, transparent, low-cost smart beta strategies” that people can easily and inexpensively invest in.
According to Research Affiliates, the historical results for the U.S. market suggest investors can earn an average value-add of 2.19% a year across these six smart beta strategies.
These strategies also indicate strong diversification benefits by combining the strategies into a multi-factor portfolio.
“Theory suggests that the returns and value-add of a multi-factor smart beta portfolio should be similar to the average values of the factor strategies, but achieved at significantly lower risk levels,” the paper states.
Research Affiliates makes the case that multi-factor smart beta investing paves the way for a smoother path to outperformance.
3. 2 Methods of Combining Smart Beta Strategies
Research Affiliates finds that multi-factor equity investing combined with either dynamic or systematic rebalancing is a reliable strategy for outperforming the market without the burden of excessive volatility. To use a systematic rebalancing strategy, allocate one-sixth of a portfolio to each of the six strategies and then rebalance back to a one-sixth allocation every quarter, according to Research Affiliates. This strategy essentially would reduce exposure to popular factors that have outperformed over recent years, while increasing exposure to the out-of-favor factors that have underperformed.
To use a dynamic rebalancing strategy, set a default weight of one-sixth to each strategy and then modestly tilt allocations based on short-term price momentum and long-term price mean-reversion signals at each quarterly rebalance, according to Research Affiliates.
The paper finds that dynamically rebalancing factor exposures using short-term momentum and long-term reversal further improves the return.
“Nearly a full percentage point in return … is produced by dynamic rebalancing relative to the average individual factor strategy, with value-add rising from 2.19% (average) to 3.16%,” the paper states. “The extra value added from dynamic rebalancing relative to systematic rebalancing is also substantial, rising from 2.45% to 3.16%.”
— Check out Smart Beta: Which Strategy Works Best Over Time? on ThinkAdvisor.