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Why Factor Tilts Make Sense and Implementation Differences Matter

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Why Factor Tilts Make Sense and Implementation Differences Matter A reprinted article from July/August 2018 Why Factor Tilts Make Sense and Implementation Differences Matter By Daphne Y. Du, PhD, CFA®, and Dan Price, CFA®, FRM® © 2018 Investments & Wealth Institute®, formerly IMCA. Reprinted with permission. All rights reserved. JULY AUGUST FEATURE 2018 Why Factor Tilts Make Sense and Implementation Differences Matter By Daphne Y. Du, PhD, CFA®, and Dan Price, CFA®, FRM® t is hard to read, watch, or listen offer better risk-adjusted returns than factor tilt strategies: the aim to capture to financial media today without a market-cap weighted index, and tilts persistent risk premiums associated with Ifinding references to factor tilts, offer opportunities to tailor portfolios to well-researched stock attributes, and the smart beta, scientific beta, and style meet specific risk and return objectives. use of transparent, systematic, and rule- or factor investing. We refer to all of based implementation with large these as factor tilts because there is Although the term “factor tilt” is relatively liquidity and capacity. These strategies no agreement on common definitions new, the concept of factors is familiar to are usually long-only, without deriva- for these terms and it is not the label many investors. From the most well- tives or leverage, and they often deviate but the strategy design that matters, known market factor of all, beta, which from a market-cap weighting scheme. e.g., choice of factors and how factors was described in the capital asset pricing Our goal is to explain why factor tilts are translated into portfolio weights. model (CAPM) (Lintner 1965; Mossin make sense and to highlight important Significant assets have flowed into 1966; Sharpe 1964; Treynor 1961) to the portfolio construction details. strategies under this theme in pursuit of value and size factors vetted in the semi- simple, transparent, systematic sources nal paper by Fama and French (1993), FACTOR TILT LANDSCAPE of return beyond traditional market-cap factors have become a common means of In the past few years, factor tilt strate- weighted indexes. Through a factor lens, describing a strategy’s exposures. The gies have brought in billions of dollars each security has an array of exposures Fama-French three-factor model paved due to the popularization of factor that explain its risk and return. Altering the way for Morningstar’s style box: a investing and the tremendous growth of factor weights from those in a market- nine-square grid based on size (large, the exchange-traded fund (ETF) indus- cap weighted portfolio—a “tilt”—can mid, and small) and fundamental style try in general. The ETF industry is a solve for two significant drawbacks of (value, blend, and growth) introduced in good gauge of the evolution of factor tilt a market-cap weighted approach to 1992 and still featured prominently in strategies for two reasons: (1) ETF data portfolio construction: concentration portfolio construction today. is readily available and not subject to the and undesirable factor exposures. reporting delays that are typical for Tilting toward rewarded factors while We adopt a broad definition that cap- mutual funds, and (2) the ETF industry diversifying away unrewarded risks may tures both “what” and “how” aspects of has its root in passive indexing, and Table U.S. LISTED EQUITY ETFS 1 Index Weight AUM (Millions) AUM (%) # of Funds Three-Year Net Flow ($millions) Dividend $94,910 3.3% 61 ($5,171) Equal $77,248 2.7% 132 $18,957 Fundamentals $42,921 1.5% 81 $14,484 Market Cap (Growth/Value) $325,176 11.3% 39 $70,225 Multi-Factor $124,057 4.3% 242 $50,398 Proprietary $15,185 0.5% 122 $7,255 Market Cap (passive index) $2,165,013 75.2% 639 $544,686 Others $34,730 1.2% 100 $10,602 Total $2,879,241 100.0% 1,416 $711,436 Source: Internal calculation based on data from Bloomberg as of March 16, 2018. Categories other than “Market Cap” (passive index) and “Others” are considered smart beta. 10 INVESTMENTS & WEALTH MONITOR © 2018 Investments & Wealth Institute, formerly IMCA. Reprinted with permission. All rights reserved. JULY FEATURE | WHY FACTOR Tilts MAKE SENSE AND IMPlementation DIFFERENCES Matter AUGUST 2018 almost all products track a published Figure U.S. LISTED EQUITY ETFS LAUNCHED index. The index construction is typi- 1 200 cally transparent and rule-based, which 180 is consistent with our definition of a fac- 160 tor tilt strategy. 140 120 100 We rely on index weight and fund name 80 to identify factor tilt ETFs. If “index 60 weight” is Dividend, Equal Weight, 40 Fundamentals, Multi-Factor, or Proprietary, 20 0 or if “index weight” is Market Cap and fund name has “Value” or “Growth” in it, a fund 1995 1996 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 is considered a factor tilt fund. Of the Non Smart Beta ETF Smart Beta ETF more than 1,400 equity ETFs listed in the Source: Internal calculation based on data from Bloomberg as of March 16, 2018. Categories other than “Market Cap” United States, 50 percent of funds and (passive index) and “Others” are considered smart beta. 25 percent of ETF assets under manage- ment are now in the factor tilt category, Table FAMA-FRENCH FIVE-FACTOR PLUS MOMENTUM and more than 20 percent of ETF net 2 inflow over the past three years was into (A): Annualized Return and Risk: July 1963−January 2018 factor tilts (see table 1). In addition, over Size Value Profitability Investment Momentum the past five years, more than 60 percent Annualized Return 2.9% 4.1% 3.0% 3.4% 8.0% of the new ETFs that were launched were Annualized Risk 10.5% 9.7% 7.7% 6.9% 14.5% factor tilt funds (see figure 1). Given the Sharpe Ratio (SR) 0.28 0.42 0.39 0.49 0.55 growth in factor investing and the hun- Max Drawdown −29% −32% −28% −15% −83% dreds of strategies to choose from, it is (B): Factor correlation: July 1963−January 2018 important to have a solid understanding of what factor investing is trying to cap- Value Profitability Investment Momentum ture and how to compare strategies. Size −0.07 −0.35 −0.10 −0.03 Value 0.07 0.70 −0.18 FACTORS Profitability −0.03 0.11 A factor can be any characteristic that Investment −0.02 explains the risk and return of a group of Source: Internal calculation based on data from Fama-French’s research library at http://mba.tuck.dartmouth.edu/pages/ securities. The most compelling factors faculty/ken.french/data_library.html are those with plausible explanations, those with explanatory power that is is often cited as the father of growth factor, and an abundance of research significant and expected to persist, and investing. Price’s eponymous firm, suggests momentum exists in many those that offer a premium relative to founded in 1937, has built its investment asset classes and markets (Asness et al. a market-cap weighted alternative. process around a focus on earnings 2013). Banz (1981) first identified size Fundamental and technical equity fac- growth with a long investment horizon. as a factor found in small-cap stocks tors have received the most attention Academic factor research also dates that carry a premium. Novy-Marx and will be our focus. Fundamental back many decades. Ross (1976) popu- (2013) made one of the first cases active managers were responsible for larized the term “factor” in his work on for profitability as a factor. Novy-Marx some of the earliest work on value and arbitrage pricing theory. Ross (1976) measured profitability as a ratio of a growth factors. Benjamin Graham and challenged assumptions made in CAPM firm’s gross profit (revenue minus David Dodd are credited with establish- and laid out the idea that multiple fac- cost of goods) to its assets, and found ing the discipline of value investing. tors explain the risk and return of this factor had an ability similar to the Their influential work,Security Analysis securities without specifying an exhaus- ratio of book value to market value to (Graham and Dodd 1934), suggested tive list of what those factors might be. explain the variability of equity returns that buying equities at a discount to This opened the door for empirical stud- as well as a return premium. This their intrinsic value would provide a ies on the efficacy of various factors. profitability factor also has been margin of safety and suggested screen- referred to as quality. ing stocks on low price-to-book value Jegadeesh and Titman (1993) and and low price-to-earnings ratios as a Carhart (1997) found evidence of return A standard way to evaluate a factor’s risk means to preserve capital. T. Rowe Price premium associated with a momentum premium is to construct a portfolio that INVESTMENTS & WEALTH MONITOR 11 © 2018 Investments & Wealth Institute, formerly IMCA. Reprinted with permission. All rights reserved. JULY AUGUST FEATURE | WHY FACTOR Tilts MAKE SENSE AND IMPlementation DIFFERENCES Matter 2018 Figure FACTOR CUMULATIVE RETURN—JULY 1963−JANUARY 2018 for example by discounting resulting 2 risk-adjusted returns by as much as 12.00 80.00 50 percent. Instead, we recommend 70.00 10.00 investing in factors that have proven to 60.00 generate consistent risk premiums over 8.00 50.00 time and across markets and have a 6.00 40.00 solid economic foundation. 30.00 4.00 Gro Gro 20.00 PORTFOLIO CONSTRUCTION 2.00 10.00 Most discussions about factor investing 0.00 0.00 stop at the point when a factor risk premium is documented.
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