In part 1 of this article, I talked through the first out of the three takeaways. In this article, I will talk through the remaining two takeaways.
Factors, Factors, Factors
The topic of factor investing, strategic beta, smart beta, or whatever you choose to call it is unavoidable these days. The theme was threaded throughout our conference agenda, as it is an area where investors continue to have more questions than answers. We were fortunate to have a pair of the industry’s foremost experts on hand to share their thoughts: BlackRock’s Andrew Ang and Research Affiliates’ Chris Brightman.
Ang literally wrote the book on factor investing.1 In his presentation, he emphasized that factors are nothing new. The first widely recognized reference to value investing was made in Benjamin Graham and David L. Dodd’s “Security Analysis,” first published in 1934. The idea that buying cheap stocks is generally a winning strategy is decades old. The same can be said for momentum, which was effectively captured in Edwin Lefevre’s “Reminiscences of a Stock Operator,” published in 1923.
What’s new about factor investing, per Ang, is the manner in which investors can gain access to factors. Today, there are 661 ETFs that Morningstar includes in its definition of strategic beta. These funds seek to exploit one or more factors in an attempt to improve returns relative to a broad market-cap-weighted index, reduce risk, or some combination of the two. Meaningful advances in information technology, academic research, and investment technology have laid the foundation for the flourishing of factor funds. So although factors themselves are not new, the fact that investors can obtain factor exposure via a low-cost, transparent, tax-efficient, ETF is still a very fresh phenomenon.
But if factors’ popularity has surged and they are now more readily investable than ever, what’s to say that they will persist as more investors seek to exploit them? Ang argued that a combination of rewarded risks, structural impediments, and behavioral biases explain factors’ historical return premiums. His opinion is that many of these drivers will stand the test of time, particularly those that are economically intuitive (value) and are rooted in ages-old patterns of investor behavior (momentum).
Research Affiliates’ Brightman cautioned that investors may become overly enamored with these shiny new toys. In his presentation, he highlighted some of the potential pitfalls investors face when using factor funds. The first has to do with valuations. Factors, much like asset classes, will experience regular cycles of relative out- and underperformance. Thus, investors must be cognizant of the value of value, the momentum of momentum, the value of momentum, and the momentum of value. This was a point emphasized by Ang as well.
If these factors have generally delivered long-term excess returns, why should investors care about these short-term cycles? As I’ve emphasized time and again in these pages, understanding that factors are cyclical is crucial, as it will foster better behavior. Factor timing is folly. But we have seen regular examples of investors attempting to time their factor bets, to unimpressive results.
Brightman also underscored the importance of approaching new factor funds with a healthy dose of skepticism. Many new factor ETFs have been launched in recent years that track indexes created for the express purpose of being the foundation for a new fund. These indexes are often the product of a collaborative effort between the ETF sponsor and an index provider. Their back-tested performance will invariably be appealing. Their real-world results, as recently documented by Brightman’s colleagues,2 have been mixed at best. Brightman quipped that it’s almost as if there is something about filing for an ETF that makes its index stop outperforming. Back-testing is to strategic-beta ETFs as incubation is to active funds. Bad back-tests never see the light of day. So be careful not to rely on simulated performance when choosing these funds.
Strategic beta is the new active. In many ways it is an improvement upon the “old” active. These funds have lower fees, their processes are more systematic and transparent, there is no key-person risk, and—in the case of strategic-beta ETFs—they are far more tax-efficient relative to actively managed mutual funds. But they are still, for all intents and purposes, actively managed funds. Some will beat the “market,” others won’t. Framing strategic beta as a new form of active security selection and portfolio construction should help investors to approach these funds with eyes wide open.
We Are Not “Econs"
Our luncheon keynote this year was an engaging conversation between Ritholtz Wealth Management’s Barry Ritholtz and Richard Thaler, the Charles R. Walgreen Distinguished Service Professor of behavioral science and economics at the University of Chicago. Thaler has spent decades debunking the notion that we can truly be rational economic actors, or “econs,” as he is fond of saying. It is perhaps not surprising that his field of study, behavioral finance, has been viewed as a form of misbehavior in and of itself by many of his peers who advocate more-traditional models of economics that assume that we are econs. In Thaler’s mind behavioral economics is messy, while traditional economics is “precisely wrong.”
During his career, Thaler has collected ample evidence to support his case that econs, like the most widely recognized embodiment of logic in pop culture, Mr. Spock, are fictional characters. This body of evidence includes bubbles and bursts, naïve diversification, and our tendency to prioritize paying down large debts over those that have greater interest rates. All of these bits of evidence reflect the fact that our brains have been hardwired to prioritize survival and procreation and not necessarily to make cool and clear-eyed decisions about our finances and investments.
Are we in a bubble today? Per Thaler, “We all should be worried about high prices and infinitesimal volatility.” He added, “Given today’s news, that’s hard to understand. I wake up every morning, read the newspaper, and get scared.”
We are our own worst enemies. In my mind, controlling our own bad behavior is the biggest barrier to living long and prospering.
1 Ang, A. 2014. “Asset Management: A Systematic Approach to Factor Investing.” (Oxford Univ. Press).
2 Li, F., & West, J. 2017. “Live From Newport Beach. It’s Smart Beta!” https://www.researchaffiliates.com/content/dam/ra/documents/626%20Live%20from%20Newport%20Beach%20Its%20 Smart%20Beta.pdf