Factors: An Essential Part of Any Nutritious Portfolio
We recently posted a piece on factor investing (here) so we were thrilled to have an opportunity to see Dr. Andrew Ang and Don Raymond discuss factor investing at a seminar in Toronto last week. Dr. Ang is Ann F. Kaplan Professor of Business and Chair of the Finance and Economics Division at Columbia Business School, while Dr. Raymond is Adjunct Professor of Finance and past Chair of the International Centre for Pension Management at University of Toronto’s Rotman School of Business. We should note that Dr. Raymond is also the former Chief Investment Strategist for the $220 billion Canada Pension Plan Investment Board (CPPIB). Don’s work on factor investing goes back more than a decade at the CPPIB, and Dr. Ang has literally written the book on factor investing with his 736 page Asset Management: A Systematic Approach to Factor Investing. Perhaps not surprisingly, Dr. Raymond uses Dr. Ang’s book as a core text for his courses at Rotman.
Unfortunately, Dr. Ang and Dr. Raymond had less than an hour to talk, so they just touched on a few broad themes. Dr. Raymond moderated the session, and opened with a brief discussion of Dr. Ang’s case study on factor investing at the CPPIB in the early 2000s. Dr. Ang began his session by showing us a video he had made to market the book, which uses nutrients’ role in nutrition as the metaphor for factors’ role in investing. Clearly, a healthy diet requires consideration of the nutrient mix in the foods we eat, not just a superficial knowledge of the basic food groups. In the same way, thoughtful investing requires managers to ‘look through’ superficial asset class labels to the factor exposures that drive their risks and returns.
Dr. Ang used Private Equity as an example of how many investors misguidedly believe they are achieving diversification by investing in alternative asset classes. He demonstrated how CPPIB, for example, decomposed Private Equity (specifically LBO) into a levered equity position and a short credit position. For similar reasons, different classes of hedge funds can’t all be lumped together under a broad ‘alternatives’ banner, but rather their sources of returns must be decomposed to understand the true risk they contribute to a portfolio.
Dr. Ang went on to cover the now ubiquitous equity market factors, value, size, and momentum, often marketed as ‘smart beta’ by the ever ingenious financial marketing industry. He reinforced, as we have so many times on this blog (see here, here, and here for examples), that the majority of active manager returns can be explained by these factors (and of course, Fama and French are out with a new 5 factor model which obviates the old 3 factor model). In fact, these factors explain over 100% of most managers’ returns (See Blake here and here, Crane and Crotter here, Fama here, Ferri and Benke here, Vanguard here, SPIVA here, etc.). In other words, most managers destroy value relative to what they could have harvested with systematic exposure to robust equity factors.
But I digress.
In discussing how to most effectively harvest equity factor bets with Dr. Ang after the seminar, he said he favoured a portable alpha framework, where market (beta) neutral factor portfolios are layered over ultra low-cost market-cap weighted stock and bond market exposures. He lamented the fact that there are no low cost market neutral factor ETFs available to investors (QuantShares charge ~1.4% net for their versions, which Dr. Ang felt was egregious).
I was curious to hear from Dr. Raymond and Dr. Ang about how well the CPPIB’s factor framework, which is based on fundamental (i.e. theoretical) financial and macroeconomic factor decompositions, predicts ex post factor attribution derived through time series regressions. The consensus from Don and Andrew was that, while liquid assets with regular pricing history are well explained by a factor framework, less liquid assets are not explained very well due to lagged pricing, smoothing, and sparse/non-existent data. I found this interesting, as they approach macroeconomic factors from a different perspective than we have proposed in the past (see discussion of clusters and principal portfolios in our article on Robust Risk Parity).
This dovetails with many of the discussions we’ve had with institutions over the past year or so about how they manage diversification through a factor lens. Senior members of investment committees seem open to factor approaches based on theoretical macro drivers, such as what we described here, but resistant to quantitative methods. This is a constant source of curiosity for us given the strong results we have observed from quantitative methods.
I’m only 8% of the way through Asset Management (per Kindle), but I can already highly recommend it for financial professionals and interested laymen alike. The book covers every major, and most minor, topics related to investment management, not just factors, and couches concepts in approachable case studies. It’s rare to encounter a text that achieves both breadth and depth in a sophisticated technical domain, but which is so accessible to non specialists.