Ten takeaways from the Inside Smart Beta & Active ETFs conference

July 19, 2019

 
Doug Grim

Doug Grim
Senior Investment Strategist

It seems asset managers, consultants, and financial advisors have collectively come to an agreement that equity factor-based strategies, whether implemented using index or active funds, are rules-based, transparent, and quantitative active approaches. That's what I heard when I attended and served on a panel at the recent Inside Smart Beta & Active ETFs conference in Boston.

While many equity factor-based funds are rules-based and have similar names, advisors should conduct rigorous due diligence. Design decisions by the portfolio manager or index provider can materially affect a fund's results. There was also lots of discussion on the topic of factor-timing. It was generally acknowledged that this is a challenging practice to pull off successfully.

With that backdrop, here are my ten takeaways from the conference.

1. Understand the philosophy and what drives it

When considering investment strategies to meet various objectives, look at the research capabilities of the portfolio manager running the fund. Understand which characteristics the portfolio manager uses to screen the stocks that go into the fund and why the manager chooses to include them.

2. Ask for proof

How extensive is the statistical evidence that supports the factor strategy? For example, has the strategy worked in different markets and for long periods of time? If it is a factor-timing approach, has it done better than a static, diversified combination of factors?

If using macro-based timing signals, how reliably have those signals predicted both the beginning and the end of different environments (e.g., contraction)? How consistent has relative performance been? Even if you have perfect macro foresight, has the factor performed in a reliable way versus the broad market and other factors during each stage of the macro cycle?

3. Assess all-in costs

Sometimes the sticker price of a fund doesn't reflect the total costs associated with it. Be sure to consider any cost-related implications such as expense ratios, ETF commissions, bid-ask spreads, market impact, and taxes.

4. Weigh timing risks

At the conference, there was lots of talk around the concept of risk, especially as it relates to timing.

Timing strategies are typically less diversified. No one should expect timing strategies to work all the time. Therefore, make sure that your clients stay disciplined through the tough times that will invariably occur along the way.

Absent a strong conviction about differences in future expected returns and correlations across factors, you should consider an equally weighted multifactor fund as a sensible, diversified starting point for most clients with excess-return objectives.

5. Prepare for patience

There was more discussion this year on the very important topic of investor discipline with factor investing. Because many equity factor-driven funds are transparent, are rules-based, and track an index, there's a common misconception that equity factor-driven funds are more conservative than traditional active funds when it comes to performance variability relative to broad market-capitalization-weighted indexes over short periods of time.

The historical evidence does not support this assumption. Therefore, you should prescreen clients to make sure they'll have the tolerance to endure inevitable bumps along the way and then coach them when such episodes occur.

6. Recognize the value of active implementation

There was some debate about whether to use index or active factor funds. In our view just because a factor fund attempts to track an index, it doesn't mean its rules are simple. In some cases, active factor funds' rules are just as or more transparent and understandable.

Managers of active factor funds have the flexibility to rebalance or invest cash flows based on the current factor exposure of stocks, rather than relying on stale exposures from the past. This can help the fund maintain a more desired factor exposure.

7. Consider a bottom-up weighting scheme when seeking a multifactor fund

Based on our research and experience and the research of a number of others, we believe multifactor funds that use a bottom-up (integrated) approach can give investors more efficient and targeted factor exposure than those that employ a top-down approach, combining subportfolios that focus on just a single factor. In general, this is because their managers can consider exposure to all desired factors when selecting stocks for the portfolio. I'll dive into this topic further in an upcoming article.

8. Understand the practical uses of factor products

Many conference attendees mentioned how advisors continue to ask how to use factor strategies in their clients' portfolios. This depends on a client's goals. The four most popular uses are to help reduce portfolio equity market risk, seek outperformance, substitute for high-cost traditional active management, or fill gaps. Visit our factor center for an example of each.

9. Set a higher bar for active equity and fixed income management

The ability to easily access a variety of systematic factor returns in a cheap and transparent way has raised the performance hurdle for equity and fixed income active managers. To justify charging higher fees, active managers with proprietary approaches must prove that they have the skill to generate better performance results after all costs and factor exposures are considered. In addition, advances in technology now enable advisors to better assess whether active funds are delivering results that justify their costs.

10. Weigh the trade-offs between market-cap weighting versus factor weighting

Market-cap weighting has its advantages, and many factor products on the market are built that way. But we believe equity factor-based strategies untethered from market-cap weighting can achieve stronger factor exposure while maintaining a high level of diversification. This could potentially give the investor the same level of factor exposure with a smaller position in a portfolio.

Next steps

The consensus from conference attendees was that interest in using equity factor strategies to help clients meet their investment objectives is clearly increasing. By asking a few important questions when choosing a factor-based fund, you can set expectations for you and your client and fairly assess if the fund is performing its intended role in the client's portfolio.

Notes:

  • All investing is subject to risk, including possible loss of principal.
  • Factor funds are subject to investment style risk, which is the chance that returns from the types of stocks in which the fund invests will trail returns from the stock market. Factor funds are subject to manager risk, which is the chance that poor security selection will cause the fund to underperform relevant benchmarks or other funds with a similar investment objective.
  • Diversification does not ensure a profit or protect against a loss.

 

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