Vanguard, the US investment house, provides guidance on factor investing - its potential bonuses and pitfalls.

A recent trend in the investment industry has been around what is, in the mind-bending vocabulary of this industry, called “smart beta” or “factor investing”. According to the Investopedia definition, smart beta “defines a set of investment strategies that emphasise the use of alternative index construction rules to traditional market capitalisation-based indices. Smart beta emphasises capturing investment factors or market inefficiencies in a rules-based and transparent way."

Vanguard, the US-based firm, is a major player in the index-fund sector – in fact it has been a pioneer in this space – and it needs to innovate to stay ahead of its peers in a ferociously competitive field. So smart beta is an important area for Vanguard. In this item, Janine Menasakanian, head of wealth for Vanguard, sets out a guide on the field. We hope the article is useful and, as always, we invite readers to respond.

What are factors?  

Factors can be described as the DNA of an investment fund. They are the component parts that determine how the fund lives and breathes, what it responds to, how it behaves, and its character. Factors explain drivers of an investment’s risk and return. For example, the return for a market-capitalisation index fund that closely tracks its index is the market factor, or beta. Investment returns for other strategies are likely to be a combination of the market and any investment styles favoured by the portfolio manager such as value, growth or small-cap stocks. There may be even some alpha due to the portfolio manager’s security selection or market-timing skill. 

Factors are often associated with investment premiums, which explains the investor interest. Common equity factors are value, size, momentum, volatility and quality. Favouring inexpensive stocks relative to a company’s fundamentals, small-cap stocks, stocks with recent share price gains or stocks with less volatile share prices have all offered attractive returns over the long term. Factors exist in bond markets too. The term factor describes long-dated bonds earning a premium over short-dated bonds. The credit factor is lower credit quality bonds outperforming bonds of higher credit quality.  

What is factor-based investing? 

Factor-based investing has many labels. Some refer to it as smart beta, enhanced indexing or alternatively weighted strategies to name a few. But the common characteristics of these strategies are that they are rules-based and that they aim to capture systematically the premiums associated with one or more factor. 

In some cases, the factor exposures will be tactical and time-varying and therefore likely a consequence of stock picking. But where these exposures are consistent, it might be possible to substitute them for a low-cost alternative.

Considerations for investors - factors explained

The aim of factors such as value, liquidity or momentum is to enhance returns, and to do so at a low cost.

Minimum volatility and its use in a portfolio is different. Its purpose is not to enhance returns but to manage absolute levels of risk, possibly to offset high-volatility exposures in other active equity allocations. It is likely to be suited to portfolios with long-term horizons with a high tolerance for tracking error. 

Minimum volatility differs from low volatility. The latter weighs only individual stock variance, typically leading to a smaller opportunity set and the risk of introducing unintended risk through country, sector and stock concentration. 

A strategy targeting minimum volatility, by contrast, can be structured to optimise co-variance across a universe of securities, helping to extend the opportunity set, including the application of concentration constraints. 

Overall volatility can be further reduced through currency hedging. This needs to be done without producing a portfolio biased towards the home currency, which would introduce an unintended risk. The solution, in our view, is to use local equity volatilities and correlations, hedging net currency exposures and reducing the overall volatility caused by currency 
movements.

In recent years minimum volatility strategies have been exceptionally successful. Simulated back-testing for the years 2001—2014 shows minimum volatility returning 11.5 per cent annually on volatility of 8 per cent. This compares to an annual return of 7.5 per cent for the FTSE Developed All-World Index, with volatility of 16.2 per cent. 

Momentum is one of a number of factors that investors can target when trying to outperform the broader market. The momentum factor means that short-term share price increases, typically over six months and up to a year, can be an indicator of future outperformance. 

Momentum investing draws on the phenomenon of recent strong share price performance continuing to appreciate in value. A phenomenon that investors are often warned against. 

This type of strategy is not a call on market direction. It is about selecting individual stocks with positive price momentum. 

Its existence suggests that investors are susceptible to several behavioural biases. Herd behaviour is a potential explanation. This occurs when individuals follow the actions of a larger group. For example, when investors pile into the same investment theme. Human nature’s desire to be part of the crowd and follow the trend is often used to explain asset bubbles. 

Another suggestion is that investors are under- and/or over-reacting to new information being incorporated in an asset’s price. Anchoring effects, in which investors place too much emphasis on unrelated events or values, could create momentum in the price regardless of the underlying fundamental value. Justifying transaction decisions with recent share price movements is a type of confirmation bias that could also explain the behaviour underpinning momentum investing. 

Regardless of why it happens, simulated back tests for a global equity portfolio for the years 2001 to 2014 show a momentum strategy returning 9.6 per cent annually. This compares with an annual return of 6.9 per cent for the FTSE Developed Index.   

While there is no definitive answer that explains why studies have shown momentum to be a successful strategy, the trend seems to be your friend when you are a momentum investor. But this adage comes with many caveats. 

We know what goes up must come down. Investors cannot expect a momentum strategy to deliver gravity-defying returns, but they can expect the potential for long-term outperformance with a factor strategy that seeks to benefit from behavioural anomalies. 

Investors choosing to target various factors need to be comfortable taking on active risk, which includes significant tracking error when compared with any reference benchmark. This also means they are likely to experience periods of underperformance and returns that are likely to be cyclical. They also need to be comfortable that the investor behaviour that underpins the strategy will continue for as long as they want to pursue the strategy.