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

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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.

One easy way to avoid stocks that emotional investors love is to sort out higher beta and more volatile securities. Historically, less volatile investments and lower beta stocks have produced comparable or higher returns than higher beta, more volatile stocks with a lower standard deviation. This means a higher Sharpe ratio and a consistent alpha.

Investors also tend to underreact to new information. When Tesla loses an important tax subsidy, investors feeling high on the company’s prospects may want to deny its impact on future profitability.

Prices tend to react to this information over time as it is fully absorbed by the traders, resulting in what is referred to as the momentum effect. Johnson notes that “we under-appreciate changes in fundamentals,” and trading on momentum can help boost alpha over time.

Is it more sensible to buy a collection of ETFs that each capture a specific factor or to combine factors into a single ETF? In addition to the practical convenience of combining factor funds into a single investment, a new crop of multifactor ETFs may give advisors an added edge by adjusting factor exposures to more effectively capture alpha over time.

Dynamic Factor ETFs

The next generation of multifactor ETF strategies can use in-depth research on factor performance during various historical periods to readjust allocations. “Generally, when you look at the factors individually, you’ll see that they tend to have certain market environments that they tend to like,” notes Feyerer.

Value stocks seem to perform better when interest rates are rising, and the momentum factor is most valuable in expansionary periods. Dynamic ETFs, such as Invesco’s Russell 1000 Dynamic Multifactor ETF, dynamic multifactor strategy will shift allocation among multiple factors based on current market conditions.

“When you take a look at factors that have been historically rewarded, and you look at the correlations of these factors, they have been historically low to negative,” according to Feyerer.

“A lot of times you can trace that back to what’s going on in the market. Over long periods of time you see excess returns for all, but you see excess performance for some more than others,” he says.

Another area where dynamic strategies can improve importance is associated with the tendency of more passive ETFs to drift from their pure factor exposure over time, as value stocks go up in price or price momentum begins to stall.

Johnson points out that “some of the more interesting developments in the factor space have been coming forth from firms like Vanguard with the nominally active management suite. They have the flexibility to incur the cost of the trade with a benefit of maintaining factor exposures over time. It brings factor investing back to its roots.”

Factor ETFs that are rebalanced quarterly or annually will suffer from factor drift as stock prices change over time. This will eventually result in weak factor exposures.

“If you have a very aggressive value strategy and you happen to rebalance when the market takes a dip, you might get lucky and get a bounce when the market is effectively spring-loaded,” says Johnson. “Having the ability to rebalance daily reduces your reliance on timing and luck.”

An advisor wading into factor ETFs may be tempted to select more common products that are susceptible to factor drift. For example, a traditional value benchmark index may hold 70% of the S&P 500.

“If you look at strategies in the value space, there’s a number that own a broad swath of equities and may not tilt as much toward a factor,” notes Feyerer. “Much as we’d counsel any investor to look under the hood with an active strategy, you’d have to take the same approach to a factor-based index.”

Impacts on Active Management

In their recently published book, “The Incredible Shrinking Alpha,” authors Larry Swedroe and Andrew Berkin discuss the impact that the availability of sophisticated factor ETFs has had on active asset managers.

The most successful active managers were smart enough to figure out how to select stocks that were more likely to outperform in the future. But their strategy was often based on their use of factors such as value and momentum. It turns out that investors can replicate the skills of successful active managers at a lower cost through factor ETFs.

“One of the things that’s changing as a result of the availability of factor exposures through ETFs is the ability to anchor a portfolio on a historically compensated factor and see a factor premium,” says Feyerer.

“It raises the bar for active managers,” he explains. “If you think about it, there really wasn’t a bar to be gauged against. If I’m a large-cap value manager, not only do I have large-cap value indexes, I have to demonstrate value that can’t be captured with an index.”

It makes sense to hold active managers to a higher bar when low-cost passive indexes, such as the equally-weighted S&P 500, are in the top 10% of their Lipper peer group. If an investor is going to pay 100 basis points for expert security selection, that expertise better generate more than a 10-basis-point beta ETF.

With inexpensive factor ETFs, active managers must justify their expense relative to a low-cost specialized ETF that includes many of the active managers’ best tricks. And as more advisors adopt a research-based portfolio strategy, active managers will feel even greater pressure to generate reliable alpha that can’t be replicated through a lower-cost multifactor product.

Plus, all-in-one ETFs that allow individuals to create complex, high quality portfolios with just a handful of assets also create pressures for advisors to justify their own fees to a client, who might ask: “What am I paying you for if you’re only going to put me in a product I can buy on my own?”

But there is an important silver lining. Rich Powers, head of ETF product management at Vanguard, sees the delegation of alpha creation to an institution as an opportunity for advisors to demonstrate value outside the portfolio.

Since generating alpha isn’t easy, leaving the pursuit of alpha to an institution allows an advisor “to spend their time on other value-added activities outside of portfolio construction.”
—Rich Powers, head of ETF product management at Vanguard

Parent firms and investment managers like Vanguard are increasingly using sophisticated ETF products to create model portfolios that advisors can adopt for a client. Since generating alpha isn’t easy, leaving the pursuit of alpha to an institution allows an advisor “to spend their time on other value-added activities outside of portfolio construction,” Power says.

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