I was recently talking to a successful active fund manager who was defending their record against that of equivalent passive funds. They made what I think was a reasonable point – that this time it really was different and that come the next big market collapse, many passive funds would be hugely vulnerable.
Their core argument was that the huge bung of quantitative easing had lifted all boats (with tight correlations between many assets) but that when markets turned, only those businesses with sound finances would survive. It’s in effect a derivation of Warren Buffett’s saying that ‘only when the tide goes out do you discover who’s been swimming naked’.
The key point here is not that active fund managers are necessarily superior to passive fund managers. In fact, I suspect quite the opposite is true.
Index firm S&P Dow Jones recently released their main study (called Spiva) contrasting active with passive funds in Europe with the key finding in the UK that over the last one-year period, 73% of UK active equity funds underperformed the S&P United Kingdom BMI. Similarly, over the 10-year period, 73.5% underperformed the benchmark.
But what active fund managers can, arguably, offer is some insight into the essential truth that not all listed businesses and thus shares are created equally. Some businesses with stellar share prices have lousy balance sheets and vice versa.
Stocks grouped into 'factors'
In the language of investing some stocks represent quality businesses with strong cashflows and decent balance sheets (and rich share prices) whilst other businesses have lousy share prices and great balance sheets and thus represent great value. Other shares tend to move around a lot less and are less volatile (low volatility stocks) while others rise more rapidly than the rest of the market and have strong momentum. In the last category there’s a huge universe of stocks with smaller market capitalisations that are much riskier in share price terms but offer huge potential if they succeed.
What I’ve described are some of the main ‘factors’ identified by economists and stock analysts, all of which allow one to pick a sub set of stocks with superior performance – some of the time. In sum, quality, value, momentum, and smaller cap stocks are all factors. Active fund managers are very good at identifying these types of stocks and there’s a huge sub industry of consultants who pigeonhole actively managed funds into boxes that say value/quality/momentum/smaller cap.
Why this obsession with all these factors? Put simply, there’s an Everest-sized mountain of research that during both recessions and bull markets certain types of stocks outperform, mostly those boasting certain ‘factor’ characteristics.
At which point two problems emerge. The first is that those active fund managers charge you a great deal for that expertise and most of the time fail to deliver on their promises. Secondly, those investors who choose to use passive funds as an alternative are mostly forced to use indices such as the FTSE 100 and the S&P 500 which simply buy all the market, regardless of the factors I mentioned above.
ETFs offer middle ground
There is though a middle way, namely investing in funds which track an index which isn’t like the FTSE 100 or S&P 500 but is instead based around a factor. The big benchmark indices are market cap indices (they weight their constituents by market capitalisation) whereas the alternatives weight the stocks by using the factors I mentioned.
This gives rise to what’s variously called factor, style or smart beta indices and their accompanying exchange-traded funds (ETFs). These are in effect a middle way between active and passive and for some investors, some of the time, in some markets they can make a lot of sense.
It’s also true that many professional advisers who use passive funds also make extensive use of these smart beta ETFs, as do ‘robo advisers’, with many using funds provided by investors such as Dimensional, a US-based outfit that features a long list of heavy-hitting academic advisers.
The really smart thing about all these factor funds is that costs aren’t that much greater than for ordinary plain vanilla ETFs. The table below is from a recent report by Morningstar which looked at the take-up of smart beta ETFs worldwide. It shows that you’re really only paying an extra 0.1% to 0.2% over a bog standard ETF compared to anything between 0.5% or 1% for an equivalent actively managed fund which might use almost the same strategy, but not admit it.
|Average||Combined (%)||Equity (%)||Fixed Income (%)||Commodities (%)||Alternative (%)||Allocation (%)|
|ETPs ex-Strategic Beta||Asset-weighted||0.25||0.24||0.22||0.32||0.42||0.54|
Source: Morningstar Direct, Morningstar Research. Data as of 31/12/18.
Factors beat the market
The other smart feature is that these factor or smart beta funds can also deliver superior returns to both actively managed and standard index benchmarks.
Back to S&P Dow Jones and their extensive range of European indices (both benchmark and factor based). They’ve crunched returns from a full range of indices over the last 10 years and compared those returns against their key European benchmark, something called the S&P Europe 350 index.
The chart below shows the results. It clearly demonstrates that quality and low volatility indices have performed much better than their peers, giving investors better than benchmark returns with lower risk levels (as measured by annualised volatility). Intriguingly, at this 10-year level in Europe most of the popular factors perform much better than the plain vanilla benchmark. Of the 11 factor families identified, all have produced higher returns with five of the 11 boasting lower levels of volatility.
Source: S&P Dow Jones Indices LLC. Data as of 31/12/18.
What’s not to like? Cheaper than active but potentially offering better returns that are far superior to plain old bog-standard index trackers.
But there are glitches...
The catches are sadly legion. The first is that there are dozens of different strategies and then many versions of the same strategy from different index firms. The choice is massive and overwhelming.
One version of a value index might look radically different than another which sounds exactly the same. Another problem is that different factors underperform and outperform at varying points in a stock market cycle: sometimes value is hot, sometimes not. Picking which index to go for is a thoroughly active process and liable to result in poor results.
There are also some very practical problems surrounding the various choices. Take the size effect. It’s been proved that most investors can harvest superior returns from investing in smaller cap businesses over the long term. The returns are more volatile but if you are patient , you’ll be rewarded with bumper returns. The snag is that there are almost no smaller cap passive funds, with the exception of a strange variant called equal weight indices, which spread their holdings equally between all constituent stocks, whether they be large or mid or small cap.
One final snag. There’s a Ben Nevis-sized pile of academic work that says investing in stocks with positive momentum works a wonder in most markets. Pick the stocks with the strongest relative strength versus the index and then ride the bull market. It’s a great plan but there are almost no momentum funds in the UK.
Five ideas for making use of factors
So, what to do? Give up on the smart beta or factor funds idea altogether? No. Be careful about choosing funds and hugely cynical about the claims advanced for these funds but do think about making some judicious stabs at a smarter form of investing. I would suggest five simple-to-implement ideas.
1) If you want to invest long term in a broad basket of global equities give serious thought to two sets of tracker funds. The first is a strategy that invests in quality stocks within this universe i.e businesses with good balance sheets, decent dividend payouts and less volatile shares. Another variant for more defensive investors is to invest in what are called low or minimum volatility versions of the global indices, which invest in similar types of stocks but with much less turbulence in the share price.
2) In the UK I think dividend-based strategies do make sense and I’ve written before about ETFs that invest in stocks where the business has been consistently increasing their dividend payout for many years. Other versions weight the stocks in the fund by the size and reliability of the dividend payout. I think these can make a massive amount of sense for patient investors
3) In Europe, I think low volatility strategies are also a smart idea if only because many European markets can be very volatile, knocked one way or the other by currency worries, fears about the eurozone and weak economic growth.
4) In the US I have a special soft spot for value-based strategies this late in the cycle, and I think they might offer some more downside protection if the US markets do start to wilt. I am a particular fan of indices which use a system devised by award winning US economist Robert Shiller, called the Case-Shiller indices, tracked by ETFs. If you think I’m being much too cautious and reckon US equities will continue to grow, then consider investing in an S&P 500 tracker which is equal weighted – this gives extra prominence to stocks with a smaller market capitalisation.
5) Last but by no means least we’ve seen the emergence of multi-factor ETFs where the manager uses multiple factors and then moves between the various ideas. These can be black boxes and difficult to understand but they could also be a brilliant idea. There is an argument that by using, say, three or four factors, you screen out a long tail of stocks that are so pointless or bad that they don’t fit in any factor screen. I’ll be returning to these multi-factor ETFs in a few weeks.
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