How to Implement a Factor-based Smart Beta Investing Strategy

At the heart of smart beta investing is the notion of re-writing investment rules to seek to improve investment outcomes by targeting exposures to intuitive, well understood investment ideas – what quants would call factors. You might think of factors as the DNA of a stock or bond: the characteristics that help explain its behavior over time, just like the chromosomes that govern a person’s creative ability or the color of their eyes.

Focusing on four factors

Industry pundits might not agree upon much, but there is a fair bit of convergence around the set of equity factors that have historically been rewarded. Four of the factors most often cited as potential sources of incremental return are value, quality, momentum and size. (See a good list of published research at the end of this post). Each of these are intuitive and well understood investment ideas. What’s more, they tend to have a low correlation with each other over the long term, as each factor is driven by very different investor behaviors or structural anomalies (Source: MSCI 12/31/14). That makes these factors a potential source of incremental returns over the long run, and highly diversifying when combined together in a portfolio.

Of course, these investment ideas are not novel – many have been part of the stock selection framework for active managers for decades. Smart beta strategies allow investors to access these potential sources of return in a transparent and low cost form.

We see investors incorporating smart beta factors into portfolios in two distinct ways, depending on the investment outcome to be achieved and how hands-on the investor wants to be in managing their allocations:

  1. Single factor strategies: Tactically minded investors may find single factor strategies a useful tool to express their views. Indeed, the cyclicality and low correlations among factors make single factor strategies a potential way to alter their portfolio’s factor DNA and express investment ideas.
  2. Multi-factor strategies: For the less tactically minded, a strategy that invests across multiple factors can provide a diversified approach. While each factor strategy may be individually compelling, they may be even more compelling when combined together as a result of their low correlations with each other.

The first quarter of 2015 provides an excellent example of why diversification among factors can be so effective. As my colleague Russ Koesterich points out in a recent post, economic data was mixed over the first quarter, with sluggish economic growth, a soft jobs report and weak manufacturing reports leading to diminishing consensus around company earnings. High quality stocks, with higher return on equity and more stable earnings on average, tend to be more defensive and therefore perform well in times of rising uncertainty. This flight to quality often leads to a shift away from more value oriented securities.1

The take away?

Whether you bring together multiple factors to seek deliberate and diversified outcomes or single factor ETFs to implement more precise views – smart beta factors can be useful tools to gain transparent and low cost access to the intuitive and long-standing investment ideas that drive performance.

Published research showing the historical outperformance of these factors includes:

1 Value: J. Lakonishok, A. Shleifer, R. Vishny, “Contrarian Investment, Extrapolation, and Risk.” Journal of Finance, 1994.

Momentum: N. Jegadeesh and S. Titman, “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.” Journal of Finance, 1993.

Quality: R. Sloan, “Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings.” Accounting Review, 1996.

Size: Banz, Rolf W. “The relationship between return and market value of common stocks” Journal of Financial Economics” 1981.

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