Factor investing is simply an evolutionary stage of active, and it can benefit client portfolios. Meanwhile, low-cost traditional active can survive.
Despite taking many lumps in recent years, active management remains relevant. But advisors and investors are fleeing high-cost, low-performing active that’s based on outdated strategies. Instead, the future of active lies in low expenses that allow investors to enjoy a comfortable share of returns. Active’s future also rests with such methods as factors and so-called smart beta investing, which seek to isolate variables responsible for market outperformance.
That is the message from Tom Rampulla, managing director of Vanguard Financial Advisor Services™.
Yes, it is true, Rampulla said, that advisors and investors have siphoned money from traditional active funds for ten years now. For example, $835 billion came out of domestic active equity mutual funds from 2007 through 2015 while $1.2 trillion in net new cash and reinvested dividends poured into U.S. equity index funds and ETFs. (1)
Assets in index funds and ETFs have continued to increase
Such numbers are stark, and they reveal some of the underlying problems with traditional, high cost active management, Rampulla said. First and foremost, it simply costs too much. Those costs drag down returns and contribute to often poor and unpredictable performance. In fact, a comparison of fees charged by active managers with the returns realized by investors in active funds paints quite the unflattering picture of the managers. (See figure below)
High fees: Good for managers, bad for investors
Asset management fees versus excess returns
Percentage of active managers outperforming (12-month average)
And the data suggest that active managers have been getting worse in their ability to outperform the markets over the decades. Ironically, a major reason for this has been the very rise of the professional investor class, Rampulla said. Several decades ago, it was easier for professional investment managers to beat the market, because market participants included a greater proportion of individual and other relatively untrained investors.
Even as the percentage of professionally managed assets has climbed, so has the number of investment professionals. “So instead of a handful of investment professionals trying to outsmart a bunch of individual investors, as you had in the past, you now have a bunch of professionals trying to outsmart one another,” Rampulla said.
For investors who placed their faith in those active managers, the result in recent years has more likely than not been a disappointment.
“The markets incorporate new information into asset pricing almost immediately—so it’s really difficult to get an edge,” he said.
Yet that’s not to say that active management can’t be successful, he added. It can be.
“There clearly are successful managers, even if they do not always outperform, and there are reasons behind their success,” he said. “The secret sauce behind active outperformance is, in fact, being replicated in a lower-cost way.”
Research over the past 20 years has shown that particular factors can help securities outperform what would otherwise be expected in an efficient market, improving returns compared with those achievable by the broad market. At least seven factors appear to provide historical, if inconsistent, equity outperformance: market, size, quality, low volatility, liquidity, momentum, and value (See figure below).
Factor-based investment excess returns and volatility
Active managers are aware of these, and studies show that factor exposure is responsible for the majority of active managers’ success in delivering excess returns. One study asserted that up to 80% of the alpha generated by active managers could be credited to factors.(2)
Now factors are being implemented with passive tools and wielded—especially by advisors—in an undeniably active way. Subasset- class index ETFs and non-market-cap-weighted indexes are replacing traditional, active methods of portfolio construction—allowing portfolio managers, and advisors, to express their views about the market.
“The factorization of active management will count as a major evolution of active management,” Rampulla said. “Yes, it does have a role in client portfolios, as does low-cost active in general.”
One example of an effective factor product, Rampulla added, is Vanguard Global Minimum Volatility Fund. It is an active fund, not an ETF, but it is based on a quantitative model and offered at a fraction of the cost of many traditional active funds.
“For retired clients who are drawing down their portfolio, a product like this helps them potentially get equity exposure and returns with less risk, and so it makes sense for an advisor to use minimum volatility at the core of such a portfolio,” Rampulla said.
Factors don’t just work in isolation. In fact, they can be combined to potentially reduce risk. “That can create a powerful combination,” Rampulla said.
However, there are three caveats to factor investing.
First, factors should be implemented as part of a global portfolio, to increase diversification.
Second, factors tend to be cyclical, and they can produce long periods of underperformance. That’s where advisors can help clients, Rampulla said. Advisors can act as behavioral coaches when strategies require a level of patience over a period of time that could stretch on for years.
Finally, factor investing should come at a lower cost, because it can be implemented systematically, and that should help increase portfolio returns.
Rampulla said the more nuanced approach of factor investing using ETFs provides greater transparency, because holdings will be reported daily; control, because securities selection should not migrate into various area of the market; and lower cost, because managers are not trying to, for example, select individual stocks or make macroeconomic predictions.
“For many of your clients, broad passive vehicles will suit their performance needs by simply staying true to a benchmark,” he said. “But for those seeking to outperform—and who accept the corresponding additional risk—we think a rules-based implementation of factors will provide an easier way to target the exposures you and your clients want in a portfolio.”
As for traditional active management, Rampulla said, that will survive, too, but not in its present high-cost format.
“Costs matter. They always will,” Rampulla said. “In a low-return environment, like that which we’re expecting for the foreseeable future, costs become even more critical.
“You can use factor ETFs to potentially help enhance client risk-adjusted returns, or you can hire active managers, who themselves will likely use some form of factor investing. In either case, your clients can win, and if your clients win, you win.”
(1) Investment Company Institute, 2016. 2016 Investment Company Fact Book. Washington, D.C.: Investment Company Institute.
(2) Jennifer Bender, P. Brett Hammond, and William Mok, 2014. Can alpha be captured by risk premia? The Journal of Portfolio Management 40(2):18–29.