Factor / Smart Beta Investing

I couldnā€™t find a thread on this so thought itā€™d be worth creating one as factor investing seems to be quite a hot topic in the last couple of years and seems to be a big area of growth.

A lot of investors have made the jump from active management and stock picking to passive investing over the past decades and now some of those passive investors are making the next step towards factor investing.

What is factor investing / smart beta?

Factor investing is a strategy that chooses securities based on attributes that are associated with higher returns. In recent research a lot of active managers returns in excess of the market have been shown to be a result of factor exposure, rather than stock picking (alpha).

It is possible to replicate exposure to these factors using an index, without having to pay an active manager to pick stocks. This has been dubbed ā€˜smart betaā€™ to differentiate it from the standard beta of market returns.

Wikipedia
Investopedia
Blackrock - iShares - Smart Beta Investing
Fama and French Three Factor Model

List of Factor ETF on Freetrade

Value

Size

Quality

Momentum

Volatility

Yield

Discussion

In terms of my own preference Iā€™m leaning towards having greater Small Cap and Value factor exposure in my portfolio as I believe this will provide greater than market returns in the future (to be clear this is not investment advice). This is primarily based on the original Fama-French 3 factor model.

Iā€™d love to hear otherā€™s thoughts on factor investing in general (even if you think it is pointless) as well as sentiment toward particular factors.

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I donā€™t really get it. It seems like theyā€™re trying to create a new term for what is basically stock analysis.

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You are correct in that at itā€™s core this is nothing new, itā€™s the same standard metrics that have been used in fundamental analysis for decades, however until (relatively) recently people were using those metrics to pick stocks. Factor investing is basically skipping the middle step of picking stocks and just directly investing based on those factors.

In that sense they arenā€™t really just creating a new term, they are creating a new strategy for investing that gains exposure to factors that may drive above-market returns, without the expensive (and arguably flawed) step of picking individual stocks.

Logically it makes sense to me, if people are using metrics like return on equity, YoY earnings growth and financial leverage as reasons to pick a stock (e.g. Apple) they arenā€™t really picking Apple, they are picking a set of attributes that they care about, so why not do so directly?

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Yeh, that does make sense. However, i also like the ā€˜storyā€™ of why a stock will go up, which is often lost in the data. If you read Peter Lynch, he says he picks stocks that have a story or reason to go up. I can relate more to this type of growth or value investing.

So as well as the attributes, I am also looking at the market as a whole, what i know about the industry and what i perceive itā€™s direction to be. This information is not contained within the stock data.

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Right, all of that is missed. I guess the main argument is that there is no evidence to support that any of that other information drives returns so why should investors care about it?

Haha, well I guess thatā€™s debatable as itā€™s qualitative information. I am doing my own test of stock picking versus the market e.g. s&p500 or global all cap. At the moment I think i am beating the market, but i donā€™t think i can truly say this is good evidence until itā€™s been 5 or 10+ years.

I donā€™t know if you can really say that there is no evidence as successful stock pickers have beaten the market, but it seems on average that active funds trail the market.

Right, but those successful stock pickers are almost always explained by factor exposure, survivor bias and luck. Personally, I donā€™t believe itā€™s possible to identify a skilled manager ahead of time - hence passive investing.

I do agree with your point though, I wouldnā€™t expect anyone who can beat the market (or identify active managers who can beat the market) to be interested in factor investing because obviously picking the winners would be a preferable strategy.

I donā€™t really know what factor exposure means, but anyway i see the market rate as being the baseline return, which can be achieved through passive investing, which in theory requires no knowledge. You just buy an index and never look at it.

However, each bit of knowledge that i have should allow me to beat that index by an amount compared to if i had no knowledge.

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In this case you are assuming the (capital weighted) average active investor has no knowledge. While I can easily see how some people might reach this conclusion, I give them a bit more credit.

I donā€™t really know what capital weighted average means, Iā€™d be interested to see some factor investing results vs straight up indexing. I feel like it would be more work, but will most people outperform the index.

Yeah it is more work and to be honest I think most people are probably better off sticking with a vanilla index for simplicity.

To look at historic returns hereā€™s how the 6 main MSCI world factor indices performed (with MSCI world as a benchmark)

Index 10Y Annualized return
World 10.57%
Minimum Volatility 10.96%
Quality 13.98%
Momentum 15.07%
Value 7.68%
Quality Dividend Yield 9.11%
Small Cap 9.93%

The World Momentum index has significantly outperformed the World index, I have no idea if that trend is going to continue but I think the difference is significant enough to consider. However 3 of the factor indices significantly under-performed the world index so itā€™s not like this is free money, it is another risk to manage.

Of course by definition most people wonā€™t beat the index, but perhaps tailoring factor exposure is investorā€™s best chance of coming out on the winning side in the longer term. I find the (example) hypothesis: ā€œvalue stocks will outperform the index over the next 10 yearsā€ much more credible than ā€œI will consistently pick winning stocks over the next 10 yearsā€ - which is what active managers are implying.

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I would also like to see more factor options available on FT.
Most mom and pop investors fail to make even the return of the market, a bit of a tragedy.
It doesnā€™t necessarily help to have more knowledge or to put more effort in either, see the SPIVA report for more, showing full time, highly compensated professionals fail consistently. (They donā€™t fail to get paid though)
The factors come from research by Eugene Fama and Kenneth French looking for anomalies in the efficient market hypothesis. They found that Cheap/Value stocks outperformed expensive/growth, and that small outperformed big. The idea is that you are compensated for taking higher risks, small companies are more risky than big companies. Later other factors were found. But most are not that important, and it seems once discovered they lose their power as this is now known to the market.
Value has outperformed over long time scales, but recently has underperformed, PensionCraft has a good video on this.
The tricky thing is still to make your choice and stick with it for ages. If you buy equal quantities of all of them, youā€™ve just bought the whole market!

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Interesting report ^ https://www.ifa.com/articles/despite_brief_reprieve_2018_spiva_report_reveals_active_funds_fail_dent_indexing_lead_-_works/

Do you think that active fund managers underperform because they have quarterly targets to hit. They have to constantly prove themselves short term, whereas a passive fund has nothing to prove.

@House is there any evidence of factor investing that has been backtested 100 years or so? I just realised that I have essentially been thinking about factor investing for my ISA. I have been buying Vanguard Lifestrategy and also a global all cap index, both essentially cover the whole world. However I have been trying to find a riskier asset class in the short term that will give me bigger gains over the long term.

I have been thinking that this could be small cap stocks or perhaps emerging markets. My timeframe is essentially infinite or lets say 10+ years, but i havenā€™t found a strategy that i can expect to invest in and never look at which should historically give me greater gains than just buying the whole market. Interested in either of your opinions.

Yes, try this: Kenneth R. French - Data Library.
OSAM also has some good papers on this topic.
With investing, taking higher risk is usually associated with higher returns. You can take more risk by having more in the market, i.e. less cash, less bonds.
Small cap and emerging markets are both riskier and have higher expected returns.
With Lifestrategy they get more risky up the scale, LS 100 being the most, do you want to go above this? If so then you can overweight small cap and emerging, or value etc.
Having both an LS and a global tracker only makes sense if you think the UK is going to outperform due to the home bias. (UK was cheap before the crash :person_shrugging:). If youā€™ve got the bottle then a small amount of leverage can enhance returns Cliff Asness: Leverage Is Good (Not advice, DYOR).

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What would be an example of leverage in this instance? He doesnā€™t give any. I have been looking at buying a leveraged ETF for a long term hold.

Iā€™m not sure if small cap and emerging markets do have better returns, Iā€™ve been doing some reading online of testing over ~100 year periods. Yes, I am invested in Lifestrategy 100 Accumulation, but I am looking to see if there is something that should give better returns over a long timescale. I essentially donā€™t care about risk in any time period that is less than say 10 years.

I like the idea of factor investing. There are times where a certain factor will win over the market as we have just seen recently with momentum. I dont think its suitable for a buy and hold for 10 year strategy for example. there was a jpmorgan research article comparing all the factors year by year. I will try dig it out

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Oh thanks, yeah Iā€™d be keen to see that article.

I completely agree, I donā€™t think any factor is a buy and hold without thinking about it (I think a standard index still fits there) but I think there may be times where itā€™s possible to pick out a particular factor as a winner for the next few years based on some assumptions.

For example if you think capital is going to get more constrained / expensive then perhaps quality stocks will do well due to the lower leverage.

Thanks Cameron, really interesting!

I recently got the Genuine Impact app and I noticed that a lot of my stocks were high on the momentum factor. It did cross my mind what investing across the top 10/20 in this factor would return over time.

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guide-to-the-markets (1).pdf (2.2 MB)

Page13

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Thanks, this is very interesting, it really shows the dominance of momentum stocks in the past few years of market exuberance.

It looks like Small Cap and Value stocks both do poorly during this time, however during bear markets this completely flips. For example in the 5 years (2009-2014) following the GFC Value and Small Cap dominated returns but from 2015 onwards their performance was much poorer.

So perhaps for the pessimist switching to Value / Small Cap equities might be an alternative to sitting on the sidelines in Cash / Fixed Income securities waiting for a correction. I really hope Freetrade add a value index to their coverage as this is something Iā€™d like to explore further.

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