New Vanguard research demystifies 'smart beta' success
Vanguard | 26 April 2017
Investors should think less about chasing higher returns and more about their investment goals when considering factor-based active equity funds, often labelled by product issuers as 'smart beta', according to new research from Vanguard.
In a new whitepaper, Equity factor-based investing: A practitioner's guide, Vanguard researchers outline the fundamentals of using factor, or rules-based, active equity strategies as a way investors can achieve their investment objectives, such as long-term growth or lowering volatility.
Vanguard's analysis shows that rather than targeting pure outperformance through factor funds, investors might be better off considering the kind of characteristics a certain factor can add to their portfolio – and whether they are willing to weather underperformance over short to medium timeframes.
Factor-based investing takes a systematic, rules-based approach to active investing by identifying and selecting securities based on certain performance or fundamental traits, such as accounting valuation, return volatility or recent performance. Unlike traditional active equity strategies, which rely on company-specific research, factor-based investing uses rules based on academic research to screen for securities which display certain characteristics.
Vanguard Investment Analyst, Dr Scott Pappas, a Melbourne-based member of Vanguard's global Investment Strategy Group and a co-author of the paper, said rules-based active funds offered investors the opportunity to access typically low-cost and transparent strategies with clearly defined investment styles, but that these should not be confused with traditional market cap-weighted index funds.
“In recent years we've seen rules-based active become more popular through so-called ‘smart beta’ strategies. This label is something of a misnomer as these products seek to achieve alpha, or outperformance of the market, through rules-based active strategies, rather than achieve beta, or average market return, through broad exposure to the market,” Dr Pappas said.
“The term smart beta implies that these funds capture higher returns using rules that are more intelligent than the rule of tracking a broad market cap-weighted benchmark. Some factor tilts may outperform a comparable broad market index over time, but it is more accurate to say that these rules-based active strategies perform differently to the market, rather than performing better than the market.
“Investors are increasingly using factor-based investing as a low-cost and transparent form of active management. Rules-based active strategies that tap specific performance characteristics, or factors, can offer equities investors the opportunity to complement their existing portfolio by emphasising certain performance characteristics in their fund or security choices. For example, an investor who wants exposure to undervalued companies might favour a value factor, whereas an investor who is more conservative and wants to manage risk might opt for a low volatility factor.”
Patience the secret to factor outperformance
Vanguard research has previously found that even top-performing active managers using traditional bottom-up, research-based security selection will inevitably go through periods of underperformance. Analysis in the Equity factor-based investing research paper also found that, across six key performance factors analysed – value, size (small cap), low liquidity, quality, momentum and volatility – all underperformed at some point between 2002 and 2015.
In fact, all six factors saw periods of underperformance longer than 60 months, and all underperformed the broad market by at least 7.0 per cent over a 12-month period.
The findings reflect that, like any active tilt, factors carry higher risk relative to the broad market, and therefore demand patience and conviction from investors, who must resist the urge to sell down underperforming active positions which may recover and provide outperformance over the longer term.
“Our analysis shows that trying to time exposure to different factors as their performance changes is extremely difficult. Year-to-year, performance of individual factors can vary greatly,” Dr Pappas said.
“What was apparent was that each of the factors we tracked had a greater likelihood of capturing alpha over the long-term, before costs. As well as emphasising the need for patience, this also highlights the value of keeping costs low in terms of maximising performance, including transaction costs, taxes and manager fees.”
No silver bullet when it comes to factor combinations
Factor performance can be highly unpredictable and investors are increasingly looking for ways to manage this risk. Typically, investors might combine factor funds with traditional forms of active management or use multi-factor funds to manage the differing risks associated with individual factors. Multi-factor funds combine diverse factor exposures in an attempt to reduce volatility. “It's important to note, however, that multi-factor portfolios may still maintain a high correlation to the overall equity market,” Dr Pappas said.
“There is no one-size-fits-all solution when it comes to factors. No pre-set, static weighting to different factors has a greater likelihood of outperformance over either the short or long-term. A large part of that is down to historical performance being a poor guide to how factors perform in combination. There is just no predicting which direction they'll go, and how that combination will perform relative to the underlying market.
“Investors should consider factor strategies that match their investment objectives, rather than trying to identify a sure-fire solution for outperformance. Using a factor strategy to tilt at certain equity characteristics can be an effective way of achieving better portfolio outcomes, from weathering volatile markets to capturing long-term growth opportunities.
“The main things investors should consider when selecting factors is whether their risk tolerance aligns with a factor's potential outperformance, are they willing or able to give a factor tilt time to achieve outperformance, and are they able to keep costs low enough to maximise potential alpha from a factor-based strategy.”
To see a full copy of the whitepaper online, please visit Equity factor-based investing: A practitioner's guide.