A shift towards factor-based investing or “Smart Beta” investing is gaining momentum. But the vast majority of individual investors and advisors are missing the boat.
Factor investing isn’t a new idea. Academics have been talking about it for over 40 years. Investable and cost-effective strategies have been around for about 20 years in the US. Canada lags the US market, so factor-based strategies are less common here. Unfortunately, many investors either don’t understand or haven’t even heard of factor-based investing. It’s time for Canadian investors to play catch up.
What is Factor-based or “Smart Beta” Investing?
A factor can be thought of as any characteristic relating to a group of securities that can help explain their return and risk. From an investment perspective, you want to focus on profitable factors that have positive expected returns, which are also referred to as premiums.
The 5 major and well-documented equity factor premiums are:
- Equity Premium – Stocks have a higher expected return than cash or bonds
- Size Premium – Smaller stocks have a higher expected return than larger stocks
- Value Premium – Relatively lower priced stocks have a higher expected return than relatively expensive ones
- Expected Profitability Premium – More profitable stocks (controlled for relative price and size) have a higher expected return than less profitable stocks.
- Price Momentum Premium – A stock’s recent relative out-performance tends to continue into the future and vice versa
Personally, I first started using factor-based strategies with my clients 10 years ago, when it certainly wasn’t main stream. In fact, I would almost describe my initial interest as an intellectual tangent at the time.
What gave me confidence to pursue factor-based or “Smart Beta” investing and fully implement this style of investing, was that it provided reliable and consistent results for my clients.
It wasn’t just an opinion or hunch that this would work out to be a winning strategy; there was a lot of empirical real world data to back this up. I was just following the science of investing.
Why should investors care about factor-based investing?
- Factor investing isn’t a fad. It is a winning and effective strategy that individual investors can cost-effectively implement.
- Focusing your exposure to the parts of the market that have the highest expected return (i.e. factors), creates the most efficient and profitable portfolios for investors.
- Factor investing also creates consistency and reliability in a cost-effective, tax efficient and transparent manner.
The end result is that using factor-based investment strategies should increase your probability of meeting or even exceeding your financial goals, which is really what investing is all about.
If factor-based investing has been around for 40 years, what has changed recently?
The big change is the acceptance of this form of investment in the institutional investment world. A recent study stated that 1 in 4 institutional investors are currently using factor strategies and the adoption in non-users is accelerating.
What is particularly interesting about this trend is that several of the world’s largest institutional investors, such as the Government Pension Fund of Norway with assets of over $600 billion, are widely using factor-based strategies.
Follow the smart money…
Large institutional investors are generally referred to as the “smart money”. The reason is that these large investment pools have tremendous resources to hire the brightest staff, the best consultants in the world and have access to investments strategies that aren’t available to individual investors. If the smart money starts following these factor-based strategies, then individual investors should be paying attention as well.
Reality versus hype: Is factor-based investing right for you?
Leave it to the marketing minds of Wall Street to come up with the clever name of “Smart Beta” for some forms of factor investing. As an investor, why wouldn’t you want to use a “smart” investment strategy?
The practical issue for investors is to separate the “noise” and hype of Wall Street/Bay Street versus reality … which is never particularly easy. Three points you should consider:
- Earning the excess returns offered by these premiums is no free lunch. It is probably better to use the phrase “risk premiums” because at least then you know there is risk in pursuing them. While these premiums have a high probability of adding significant value over time, they are certainly not guaranteed and individual factors can have long and painful periods of under-performance.
- Using history as a guide, I am sure people will pile into certain factor strategies after periods of out-performance and bail after periods of under-performance. Which reminds me of the saying “bear markets are when stocks are returned to their rightful owners”. It’s like anything else in investing: The weak hands will lose money using factor strategies, whereas the strong hands will make money.
- With all marketing hype there will be numerous new products formulated by the Wall Street/Bay Street marketing machines and will likely be poorly executed, high cost or not necessarily backed by sound research. This will probably lead to disappointment for investors and tarnish the Smart Beta moniker.
Investment Advisor Supervision is required….
When I first started researching factor investing for my clients, I had an opportunity to have dinner with Rex Sinquefield, the co-founder of Dimensional Fund Advisors (DFA). DFA is the one of the world’s leading firms in factor investing and started their first investable factor strategy over 30 years ago. Currently, they manage over $300 billion US for institutions and individuals. Rex stated that factor investing required “adult supervision”, which really meant that investors or their advisors should really know what they are doing before using these strategies. It also re-enforced the rationale of why DFA does not deal directly with individual investors. You can only access their strategies through an approved advisor.
Call us if you’d like to learn more about factor-based investing and if this strategy is right for you. Don’t miss the boat on this one.