Finke: How Swedroe and AQR Are Hunting Alpha (and You Can, Too)

The evidence-based investing revolution continues to transform asset management. If most of a portfolio’s return is generated from exposure to the overall market, or beta, then it makes sense to buy beta on the cheap through products such as exchange-traded funds.

Over $4 trillion is now held in U.S. ETFs, driven mainly by the desire to capture low-cost access to a diversified core portfolio. As of July 2019, nearly $600 billion of that is invested in just three popular S&P 500 ETFs.

But what about alpha? Are there ETFs that can help investors generate even higher returns?

Alpha isn’t easy to create. For every successful investor who beats the market, there must be another investor who loses.

Many financial economists have spent their careers digging for fund characteristics, or factors, that consistently add a higher rate of return than beta alone. Access to data and advances in statistical techniques have helped scientists build a list of reliable factors that could be exploited by asset managers smart enough to pick up the easy alpha that others ignored.

Every year, I have my graduate students estimate alpha from historical fund data using a range of characteristics, such as recent performance, fund family and manager tenure. The only consistent predictors are always expenses, beta, value and size orientation.

Value investors have harvested alpha so consistently that financial economists consider it the gold standard of all investment factors. Much of the success of star investors like Peter Lynch and Warren Buffett can be attributed to their attraction to small, cheap companies.

An investment in value stocks has simply been a license to take wealth away from ill-informed, emotional growth investors who consistently leave money on the table.

It turns out investing itself isn’t quite that easy. Growth investors have eaten value investors’ lunch over the last decade, happily wiping away their smug research-based grins.

Even though the gold-standard factor has lagged, industry experts such as Larry Swedroe of Buckingham Strategic Wealth and Cliff Asness of AQR Capital Management point out that factors don’t tend to be highly correlated and, when combined, can consistently produce alpha without bearing the risk that a single factor won’t be productive. Combining factors can be the smart way to capture the elusive alpha.

Smart-beta investors can take advantage of the tax benefits, low costs and liquidity of the ETF structure through a new breed of multifactor investments that hunts for alpha using a variety of research-based strategies.

The Multifactor ETF

A new generation of ETFs promises to intelligently combine research-based factors through a low-cost platform to generate better outcomes than plain-vanilla beta ETFs. This means paying attention to the research to better understand what factors are consistently generating higher returns and combining them to give investors the best shot at outperforming the market.

According to John Feyerer, senior director of Equity ETF Strategies at Invesco, multifactor ETFs “democratize access to what institutional investors may have utilized for decades. What’s game changing for investors and financial advisors is their ability to incorporate these factors into their portfolios.”

“Investors who are using traditional market-weighted strategies are making a huge bet in overvalued sectors. Indexes weight on price. Investors are getting full exposure to the whims of the market.”
—John Feyerer, senior director of Equity ETF Strategies at Invesco

What factors can produce alpha? Since researchers are constantly testing new and old factors, our understanding of which factors are most reliable and how to productively combine factors improves and changes over time. “We believe that there are five or six factors that make sense — value, size, momentum, low volatility, quality and dividend yield,” notes Feyerer.

“When you look at the criteria for a factor to be considered historically rewarded, one of the things you need to see is excess return in the full history and out of sample,” says Feyerer.

“If it was discovered years ago, does it continue to persist out of sample domestically and globally? Does it have a logical reason to exist? Is there an economic rationale for why it existed and why it should persist? Are the returns statistically significant?” he asks.

The longstanding criticism of factors is that they arise from data mining by researchers who hope to find correlations between investment characteristics and returns in the historical data. In a recent interview, Bill Sharpe discussed the possibility that many of these factors are the result of random trends and prone to disappear or even revert to a negative alpha once identified.

Ben Johnson, director of Global ETF Research at Morningstar, agrees that factors need to have a reason to exist before advisors can be convinced that they will reliably produce alpha. “It has to be something that is backed by intuition,” says Johnson.

“[A factor] has to be something that is backed by intuition. Value is incredibly intuitive — it makes sense. Buy things that are priced at less than what they’re worth. They have to be vetted by academics and practitioners. If there are two that have passed the test, I’d argue that they are value and momentum.”
—Ben Johnson, director of Global ETF Research at Morningstar

“Value is incredibly intuitive — it makes sense. Buy things that are priced at less than what they’re worth. They have to be vetted by academics and practitioners. If there are two that have passed the test, I’d argue that they are value and momentum,” Johnson explains.

If beta represents the rational reason investors in an efficient market should be rewarded for taking risk, investor sentiment represents an equally powerful explanation for alpha-generating opportunities that is backed up by hundreds of investment research studies.

This is because individual stocks and sectors of stocks tend to go through periods when they are beloved by emotional investors who bid their price above fundamental values.

Johnson believes that both risk-based and behavioral stories can “bolster an investor’s confidence that the factor will continue.” Investors often fall in love with the newest hot sectors or glamour stocks they’ve heard about on the news or at the water cooler.

“Our monkey brains kick in,” notes Johnson. If a large enough percentage of investors are using their monkey brain to pick stocks, this leaves opportunities for those who can put on their blinders and use their “Vulcan” brain to stick with boring, underappreciated investing opportunities.

One problem with traditional indexing is that periodic sentiment-driven episodes force indexes to overweight overvalued stocks. Technology stocks made up one-fifth of the S&P 500 during the dot-com bubble of 1999, and Cisco alone made up 4%.

“Why would I want to buy more and more of a company as it gets more expensive?” asks Feyerer. “Investors who are using traditional market-weighted strategies are making a huge bet in overvalued sectors. Indexes weight on price. Investors are getting full exposure to the whims of the market.”

Stock investors looking for higher returns on their equity portfolio can simply invest in higher beta stocks according to the traditional capital asset pricing model. This is especially true if they are unable to secure the leverage needed to ramp up the risk of a market portfolio.

Investors also may be attracted to stocks that are more likely to blow up in the future. (Who doesn’t want to win the lottery?) This increases the price of higher beta stocks, lowering the premium investors otherwise would have expected for taking more risk.