As a special addition to the Insurer Investment Forum, SAA’s President & CEO Alton Cogert spoke with Forum Speaker Chris Gannatti, WisdomTree to explain “Factor Investing,” it’s importance and how insurers can gain an advantage.
You can watch the full interview discussion here. Below is the transcript of our discussion (edited for clarity and space):
A: It’s one of the most interesting areas of the market today, because Factor Investing, like many investment methodologies, has been around for multiple decades. People have been writing academic papers about different factors that they believe is associated with excess returns in the open market for many decades.
What is a factor? A factor is a characteristic that is thought to be associated with an anomaly. The reason I say, “an anomaly,” is if markets were efficient – if every stock had the correct price relative to fundamentals all the time – then the best approach would be to take a market cap-weighted portfolio and hold that through thick-and-thin.
Over time we’ve seen certain things that are interesting. And those things are interesting, because they deviate from what we would think of as an “efficient market.” Meaning some prices for some stocks must not be “correct,” because things like value, quality, low volatility or momentum have been associated with a persistent ability to outperform over time. That doesn’t mean outperform every calendar year from now and forever. It means over the long haul there has been an out-performance associated with these factors (anomalies).
Over short-term periods, what’s also interesting about factors is you can use it to gauge what’s going on. For example in 2017, momentum is heading towards outperforming the S&P 500 by approximately 10% on a YTD-basis.
Why is it better than an actively managed equity portfolio in certain sectors?
A: If we’re looking at different equity strategies, very frequently we can determine, “this equity manager out/underperformed based on over/under weights of different sectors or different individual stocks, because some stocks are doing better and some aren’t.” What we can do with any strategy, whether passive or active, we can take the returns they’ve generated and we can run a regression analysis.
What you can do is figure out: an active manager is outperforming – what factors is he tapping into? In reality, based on how the factors work, every active manager is tapping into some mixture of different factors. What the factors really do is give us an additional tool, similar to attribution, that helps us explain out/underperformance of any active manager.
Ultimately, we know that certain active strategies all go through periods of ebbs and flows. What the factors can do is help give us a window into part of the reason why a manager is out/underperforming, as well as constructing portfolios. You may have one active manager tilting towards momentum and one tilting towards value. If value and momentum outperform at different times, now we have a logical way we can construct the portfolio and blend strategies together.
Have you done any work in that area?
A: Out of time, there might be a predominantly large-cap strategy, which may maintain a large-cap bias, but may find some interesting mid-cap stock. So, maybe some flexibility to put a certain percentage of the assets in “non-large-cap stock.”
One of the classic things large-cap active managers have done over time is add in some of those mid-cap stock, which if markets are doing well, would have the potential to outperform large-cap stock. Give a little “juice” to the performance and try to do something to outperform their peer group or benchmark over time; bring something into the portfolio that may not be in the benchmark. That’s one of the classic elements.
You can do the same thing if it were a value manager that has the flexibility to include growth stock if growth is doing particularly well over a period. It does give the client an ability to “look under the hood” in a returns-based analysis, such that now there’s yet another way that they can make sure their manager is doing exactly what they hired them to do and not deviating.
The way the regression will work is if there’s a small-cap bias within a large-cap strategy. That’s going to show up within the regression and the client’s going to be fully aware of how that manager is generating returns and be able to make an informed decision as to whether that fits in the larger portfolio.
Can you outline those for us and define them?
The biggest and the classic is “value” – popularized by people like Warren Buffett. The idea is you have an asset, it’s got a certain price in the market, and the fundamental or growth potential dictate that that price should rise over time. The idea that buying stuff that’s below its intrinsic value would be the “value” factor.
The “size” factor is another very popular one. A lot of us have small-cap strategies within our portfolios; the thought being these companies are earlier in their life cycle. If economic conditions improve, if their growth picture improves, suddenly these companies can respond more quickly. In some cases, small-caps are riskier than large-caps, so the investor needs to be compensated more to take the risk of owning small-cap. That would account for the “size” factor.
The “quality” factor is where things start to get interesting. Firms like GMO have different hypotheses, where we know it’d be very exciting to find the next Starbucks, next Google, next Chipotle; wherever that company is that goes from $1 per share to ~$1,000 per share, we all think of that lottery excitement. In reality, it’s those steady companies if you buy-and-hold for the long term, it’s been shown that these higher-quality firms have outperformed the market. They’re not the most exciting companies to own year-by-year, but over the course of time, if you have the patience, there has been outperformance.
Then you have low-volatility premium. Certainly sensitive to interest rates, which is important to note. Low-volatility tells us that over the course of time, losing less on the downside is absolutely an important factor to be cognizant of. Additionally, these factors are also sensitive to other things going on in the market, like the behavior of interest rates, which make higher dividend-yielding stocks more-or-less attractive.
Finally, momentum. Momentum is the classic trend-following approach, where you’re looking at the market, see a certain group of stock is performing well and absent a catalyst to change that performance, that brief performance is going to be indicative of the near-future.
It’s important in all of these strategies to always look-under-the-hood. Even though academic literature would support outperformance across the five factors, how the investment thesis is achieved mechanically could have consequences at the client level.
For those five factors, how robust is the history of returns?
If you have a long time-horizon, you would expect each of the five factors to potentially give you that outperformance in the market. What we’ve seen is, any time you diverge from saying, “the market cap of the stock dictates the exact proportion to which we will own it,” it may not be the best approach for long-term outperformance.
On the other-hand, if you say, “Amazon’s price-to-cash-flow ratio changed in such a way you have a cash-flow-weighted approach, it is one way someone can access a factor like, “value.” If you’re accessing value you could use price-to-earnings ratio, price-to-book ratio. You can use all these measures to do the same thing, which is, “I want less expensive stock with higher fundamentals,” and it’s your choice which fundamentals you think is most important.
Last year, value strategies did incredibly well. This year, value strategy has been one of the worst performers. Growth strategies, which tap into momentum (momentum is the best factor this year), suddently are the top performer. So any short period you’re going to see the factors switching leadership, which leads us to think blended approaches could be fairly interesting since we don’t predict which factors are going to outperform in the near-future.
If you’re an investor and you want to try to take advantage of all five of these strategies, how do you go about figuring out the mix?
There are strategies that equally weigh the five factors and do it on a quarterly re-balanced basis. Every quarter we’re going to analyze our portfolio and make sure 20% is weighted to each of the five factors. It’s not a bad strategy, you’re tilting into different things that have been shown to be anomalies in the market; you’ve got all your bases covered in case one is outperforming and one is underperforming.
Other things we’ve seen is you don’t necessarily have to have all five. When interest rates dropped last year, that falling interest rate environment really pushed up the price earnings multiple in evaluations of low-volatility as a factor. Suddenly low-volatility is really expensive relative to the market. Something we’ve seen done all the way around is this concept of monitoring the fundamentals of the different factors. Every factor is really a grouping of companies. If that grouping is suddenly having a PE ratio that is 20% above where the S&P 500 is, that’s telling us the expected future return for that factor cannot be necessarily as high, because it’s that much more expensive. That much harder for those companies to increase their multiples across time starting from that higher base.
Something we’ve seen people do is look at pairings. Interesting pairings might be quality and value, it might be value and momentum, where you’re getting two factors that tend to outperform at opposite times. That across time might smooth out that excess return that you’re looking for, therefore have the potential to improve your excess return / standard deviation of excess return. You want a nice excess return and you want it to be fairly stable. You can utilize factors that can outperform at different times to improve your potential of getting exactly that.
If they’re using equities today and they’re using active management today or whatever they are using today, they can utilize the factor construct to get a better handle on exactly what tilts are already in the strategy they are using today. Every investor in U.S. equities, unless they buy every stock, is tilting towards some factors and away from others. What they can do from there is utilize the new options, the new tools in the toolkit.
Twenty-years ago, if someone wanted to invest in momentum, there was no way someone could go to the market and invest in a momentum-specific vehicle. It didn’t exist. Today, that’s really what’s changed. You can buy mixes of multiple factors, the individual factors, or even create their own. The universe of indexing today, with insurance companies, that’s where we bring the value added to the table. We can help to present some of the new stuff that’s become available and how that may fit in with a broader portfolio construct.