Factor indices: passive investing’s latest evolution
WORDS ON WEALTH
Instead of investing haphazardly in whatever tickles their fancy, professional fund managers invest according to a carefully thought-out process or strategy that aims to beat a predetermined benchmark over the long term.
Before they look at individual shares (for the purpose of this article, I’ll stick to equities as an asset class), they are likely to consider the broader, so-called “macroeconomic” environment in which the market operates, although some so-called “bottom-up” managers pay little attention to macroeconomic influences.
At share-picking level, there is a range of well-tested investment strategies or styles. Once a manager has established the criteria for determining not only which shares to buy but when to buy and when to sell them, the manager needs to stick to that process through good times and bad. This applies to any investor: if you become unstuck and start letting your emotions (fear and greed in particular) rule your decisions, you will enter the investor’s nightmare of buying high and selling low.
The better-known investment styles are:
Value: the manager buys shares that are undervalued (trading at a low price) and that he or she believes will return to a price that better represents the company’s worth or “fair value”. It may be likened to eyeing an antique vase in a junk shop that you believe is worth much more than the price the shop owner has assigned to it.
Value may be measured by looking at a share’s price/earnings (PE) ratio – the price of the share in relation to the profits the company has made or is expected to make.
A distinction needs to be made between a low-priced share that is undervalued and one that is low because there is something fundamentally wrong with the company, and will continue to slide. Sometimes value managers get it wrong.
Quality: the manager selects mature companies that are well-established, well managed, and have consistently performed well through market cycles over many years. These are your “blue-chip” companies – including big-name brands, such as Coca-Cola – but also smaller or less visible companies that have a solid track record.
Besides enjoying a steadily rising share price (naturally with the odd dips that accompany market cycles), these companies typically pay reliable dividends that keep pace with or even outpace inflation. A drawback is that because they are in high demand, their share prices are high and often become overheated. Another is that many large, established companies are prone to disruption. Kodak was once a blue-chip company.
Growth: the manager buys shares in companies that show the potential for significant growth in the medium term. These are likely to be young companies in their growth phase: they are expanding rapidly and conquering new markets or winning market share from incumbents. A good example on the South African market over the past decade has been Capitec Bank.
Momentum: the manager selects shares that have become popular in the market and which are in high demand, taking advantage of the upward momentum of their price. This is the antithesis of the actions of a value investor, who will typically be “contrarian”: going against the crowd by seeking out unpopular shares.
The styles referred to above have cycles, and these may not be correlated. For example, momentum picks up once the market is enjoying a bull run and everyone is climbing in to buy. Value, on the other hand, produces results earlier in the market cycle, when shares are still cheap.
For this reason it is important to test the performance of a style, or a manager following a particular style, across market cycles. This proved difficult in the years following the financial crisis of 2008, because of the artificial stimulus central banks were giving to the markets, resulting in a far more drawn out bull run than normal.
In practice, fund management companies develop proprietary investment processes that may combine styles. For example, a manager may combine quality and value, by focusing on well-run companies that are undervalued. (Note that a dyed-in-the-wool value manager will not consider quality.)
With the swing towards passive investing – whereby a manager passively invests in the constituents of an index, thereby replicating the return of the index – market indices, which were originally used simply to measure the markets, took on a new role. This has been to provide trackable baskets of assets that share certain characteristics (or “factors”) for use by passive managers.
Clever mathematicians in the investment industry found that they could formulate indices to replicate investment styles, among other things, by dispassionately measuring metrics of companies, including share-price performance, PE ratio, and figures in financial statements.
The result was “factor” indices for the investment styles of value, growth, quality and momentum, as well as for factors such as share volatility and companies with high ESG (environmental, social and governance) scores.
The most recent development in this space has been multifactor indices, which combine factors with the aim of improving returns further. For example, Satrix’s SmartCore Index Fund, based on its proprietary SmartCore Index, drives returns through enhanced exposure to the factors of momentum, quality and value.
SATRIX'S FACTOR TOOL
At the recent Satrix conference, The Future is Factor Investing, Kingsley Williams, the chief investment officer at Satrix, demonstrated the new Satrix Factor Tool, which measures to what extent any unit trust fund in the South African general equity category adheres to the investment styles, or factors, of value, quality and momentum. Williams said these are the three factors, according to Satrix research, that are best rewarded over time.
The tool analyses the holdings of a fund (to the extent that it can - some fund managers do not disclose all holdings) and the fund’s performance against market indices.
Personal Finance put the following questions to Williams:
At whom is the tool aimed?
The tool is aimed at investment professionals who fulfil the role of portfolio constructors, such as discretionary fund managers, fund-of-fund managers, multi-managers and asset consultants. Financial advisers may also use the tool if they fulfil a portfolio construction role for their clients.
Is there a fee to subscribe to use the tool?
There is no fee. It is designed to educate the market on factor investing, so portfolio constructors are better equipped to consider factors when making investment decisions.
What is Satrix’s motivation behind developing a tool that analyses active funds?
When blending funds together into a portfolio (whether active or passive), the primary objective is typically to diversify the risk associated with a particular investment manager and their style of investing. Factors capture styles of investing, so by revealing the factor exposure of funds utilised within a portfolio blend, the investor has greater insights into whether their portfolio is well diversified from a style perspective, or whether a portfolio is overly exposed or significantly underexposed to a particular factor. Our aim is to use the tool as an opportunity to engage with portfolio constructors and clients on the role factor investing can play within their portfolios, and specifically how factor index funds provide a natural way for investors to achieve their objectives.