Investors have been piling into factor investing strategies in an effort to capture returns at a lower cost than from actively managed products. But wealth managers disagree on how to work so-called smart beta, which aims to exploit factors such as value and momentum, into client portfolios.
Steven Dudash, president of IHT Wealth Management, a $750 million registered investment adviser based in Chicago, isn’t ready to commit to the spate of new factor-based offerings. “It’s one thing if it’s a client’s fun money and they want to experiment,” Dudash says. “But if we’re talking about core holdings, I want to see a longer track record before I dive in.”
Dudash adds that he hasn’t witnessed enough customer demand for factor exposure to make a big push into the space. “Anyone can backtest anything into existence,” he says. “I want to see what these products do over the next few years before I start chasing something just because it is popular.”
Jim Cahn, CIO for the advisory arm of $4.5 billion, Minneapolis-based Wealth Enhancement Group, begs to differ. Regardless of where one stands in the active-versus-passive investment debate, factor products should be a core portfolio holding because they’re a driver of returns and a diversifier, he argues.
“Many investors don’t realize the factor exposure they already have in their portfolio,” says Cahn, who has created his own approach to factor-based investing. “We think it’s important for investors to take stock of what they already have, and then they can figure out how to capitalize on that by more deliberately managing that exposure. Unfortunately, most brokers and wholesalers don’t give investors the tools to do that.”
Asset managers who supply factor-based products also appear to be divided. Smart beta is just cheap active management, contends Yves Choueifaty, founder and CEO of Paris-based TOBAM, who agrees with Cahn that investors should be fully aware of how factors work.
“Investors need to understand what all of these terms mean, and it’s not always clear,” Choueifaty says, adding that allocating to a certain factor exposure means making assumptions about how a given stock performs. “That’s a speculative decision,” he contends. “Calling it beta and saying it’s neutral isn’t true. Risk factor investing has nothing to do with smart beta; it is about alpha, about taking advantage of insights.”
At $8 billion TOBAM, whose funds are long-only, Choueifaty has pioneered a strategy that he says provides a market-neutral and highly diversified portfolio. His investment philosophy focuses solely on maximizing diversification and capturing the attendant risk premium. By contrast, factor strategies that seek to capture returns from slicing and dicing market capitalization-weighted indexes still miss out when it comes to diversification, he says.
“At the end of the day, we believe that the market cap-weighted portfolio is the most biased portfolio,” explains Choueifaty, who in 2006 patented a measurement called the Diversification Ratio that underpins TOBAM’s Anti-Benchmark and Maximum Diversification strategies. “The portfolio will always maximize its bias systematically, at the worst possible moment — usually when prices are high — and then when the market is cheap, it will minimize its bias.”
Andrew Ang, head of factor investing strategies at $4.7 trillion BlackRock, doesn’t disagree. But Ang, whose New York–based firm has some $121 billion tied up in factor-based investments, says Choueifaty’s view doesn’t take the whole picture into account.
“Anything that deviates from the passive market index is an active decision, so factors are active in that sense,” he notes. “But that’s not the right question to ask. Factors can be done at scale and at low cost; that’s not true for all active strategies or for alpha.”
In Ang’s view, real active management should capture transient sources of alpha that may not be readily repeatable or even obvious to other market participants. For him, factors are a bridge between true alpha and completely passive investing.
Wealth Enhancement’s Cahn doesn’t believe factor diversification is necessarily market neutral. But it offers more than a maximum diversification strategy, he asserts, because it takes a view on possible performance that is biased to the upside for investors.
Cahn, who calls his process Quantitatively Enhanced Indexing, examines factor exposures already in client portfolios and adds tilts like momentum and value to core equities holdings in a bid to beat the benchmark. By examining portfolio holdings before reconstructing a portfolio or buying off-the-shelf products like exchange-traded funds, he avoids going overweight on any particular factor. Although factor tilts may lead to some short-term underperformance, investors are typically rewarded over the long haul and can enjoy the same kinds of cost and tax efficiencies they would get from passive investing, Cahn says.
No matter how wealth managers view factor-based products, TOBAM’s Choueifaty wants to see more emphasis on outcome-based investing, which he regards as the best way to avoid excess costs while maximizing performance. BlackRock’s Ang agrees. If factors are part of a portfolio, multifactor allocation works as a hedge against movement in one area due to popularity rather than fundamentals, he says; it can also help to neutralize bias.
“Investing in a single factor is pretty risky, in my view; it’s very hard to do that well,” Ang cautions. “With a multifactor approach you can lessen the risk.”