John Feyerer, CFA
Vice President & Director of Equity ETF Product Strategy
PowerShares by Invesco
PowerShares by Invesco has been a pioneer in the factor exchanged-traded fund space, with a wide-ranging offering of single- and multi-factor products that investors can use to construct their portfolios. ETF.com CEO Dave Nadig chatted recently with John Feyerer, PowerShares’ vice president and director of equity ETFs, about how investors should be evaluating factor-based investments.
Let’s go back to the basics here and talk about how we actually define a factor and how it relates to smart beta.
At its most basic level, a factor is defined as a quantifiable characteristic that explains the return and risk of a given asset or a given portfolio. Factor-based strategies have been part of the discussion both within academia and asset management for decades. Smart beta provides rules-based exposure to factors, while the ETF vehicle has democratized access to factor-based strategies.
Are there certain things that all factors have in common that make them clean and easy to understand?
First of all, factors need to be quantifiable and understandable. Think about factors such as valuation, volatility or momentum: These are easily quantifiable and understood.
Factors also have explanatory value in terms of performance attribution. With factors, investors can better understand where performance is coming from and identify what is truly alpha—or the return that is the result of managers’ skill—versus performance that is simply the result of factor exposure.
There are a few that I like to allude to as the “Mt. Rushmore” of risk factors. These are factors that have been shown to be historically rewarded with risk-adjusted return premiums. These include value, small size, momentum, quality, low volatility and dividend yield. We’ll use value as an example because it’s been recognized for decades and can be traced back to the work of Fama and French—and even well before that. When you organize universes of stocks based upon valuation and then evaluate the risk and return profile of those stocks over long periods of time and across market cycles, you see that cheaper stocks have historically earned a premium return relative to more expensive stocks. Similarly, to use volatility as an example, when you organize stocks around volatility and then examine performance relative to volatility, you actually see a premium that has historically been generated through the low volatility factor. We believe there’s a real opportunity for investors to build strategic portfolios around these rewarded factors.
Does a factor have to make intuitive sense?
It really does. For a factor to be considered rewarded, it should have a credible reason that explains its existence and, more importantly, why it may persist into the future.
These reasons can be boiled down to a few key areas. The first is a type of systematic risk. When I think about factors such as small size or value, these are rewarded factors that are the result of systematic risk.
Another area of criteria for evaluating factors involves investor behavioral biases. Think about the low volatility factor or the quality factor; these are factors that can be expected to persist going forward because of certain behavioral biases that we as investors have demonstrated and likely will continue to demonstrate going forward.
There are also structural limitations. Some examples are leverage aversion or fixed benchmark mandates. These create the opportunity for factor premiums to persist going forward. It really is important that we understand the rationale behind the persistence of the factor premium.
Another criteria for a factor to be included on our Mt. Rushmore is the factor having been identified, vetted and replicated in academic journals, and having been seen to exist out of sample.
Also, it should not be just a phenomenon that we see here in the U.S., but that has been shown to be rewarded on a global basis. Lastly, when you look at it through a statistical lens, is there excess return generated by the factor, and is this excess return statistically significant?
When you pull all this together, you have a pretty high hurdle for a factor to be truly rewarded. These are the very factors that we believe investors can use as building blocks as they construct strategic allocations within investment portfolios.
Let’s say I’ve narrowed it down, and I’ve got my Mt. Rushmore of factors in front of me. How do I put this into the context of a portfolio?
One of the phrases we use often at PowerShares is “looking at the portfolio through a factor lens.” It starts with understanding what the factor exposures are within an existing portfolio. We believe factors are to portfolios what DNA is to individuals. That is to say, DNA has an explanatory value around the traits, characteristics and behaviors that we have as individuals. Similarly, factors can help explain the risk and return profile of a given portfolio.
One of the things that’s critical to understand is just what the factor exposures are within an existing portfolio, and where there might be opportunity to bring other factors to bear within the portfolio.
Investors can use single-factor funds to adjust the exposures of an existing portfolio, or they can use single- or multi-factor ETFs to construct a diversified, factor-based portfolio from the ground up.
If I’m not somebody who’s used to thinking about that lens, what kind of tools do I need? It sounds like I need my own risk model and a Bloomberg terminal. How do I approach this if I’m not at that level?
One of the things we’ve seen is really the need to create a fairly simple construct to understand—to get a quick visual depiction on what the factor exposures are in a portfolio. We offer a tool on our website, Invesco.com/factor, that allows users to plug in an ETF or a mutual fund and see what factors are driving the returns within that particular portfolio.
In addition, we offer an in-depth portfolio analysis we call Factor DNA™ that provides a deeper dive on a more complex portfolio by revealing its factor exposures. These types of tools are very useful when it comes to understanding factor exposures within a portfolio.
If you think about how most investors have evaluated exposures within their portfolio, many times they’ll end up referring to a traditional style-box framework. This limits investor understanding of what exposures their portfolio has across the value and growth spectrum, and what exposures it has across the size spectrum. It’s very limited in scope.
A visual that we believe is much more robust is a factor DNA map—sometimes referred to as a radar chart—which shows factor exposure to quality, momentum, value, small size, low volatility and dividend yield. It can be used to show how a given portfolio’s factor exposure stacks up relative to a benchmark index, such as the Russell 3000 or the S&P 500, or whatever the relevant comparative benchmark is. A factor DNA map also identifies how exposures are driving the risk and return of a given portfolio. From there, investors can determine which individual factors may be beneficial to introduce to the portfolio.
Our factor DNA map allows an investor to understand via a single visual what the factor exposures look like, which we believe can be helpful when it comes to building better investment portfolios.
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Past performance is not a guarantee of future results. ETFs disclose their full portfolio holdings daily.
There are risks involved with investing in ETFs, including possible loss of money. Index-based ETFs are not actively managed. Actively managed ETFs do not necessarily seek to replicate the performance of a specified index. Both index-based and actively managed ETFs are subject to risks similar to stocks, including those related to short selling and margin maintenance. Ordinary brokerage commissions apply. The Fund’s return may not match the return of the Index.
There is no assurance that ETFs will provide low volatility.
Factor investing is an investment strategy in which securities are chosen based on certain characteristics and attributes.
A value style of investing is subject to the risk that the valuations never improve, or that the returns will trail other styles of investing or the overall stock markets.
Momentum style of investing is subject to the risk that the securities may be more volatile than the market as a whole, or returns on securities that have previously exhibited price momentum that are less than returns on other styles of investing.
Diversification does not guarantee a profit or eliminate the risk of loss.
The Russell 3000 Index is a broad index that includes the 3,000 largest companies based on descending total market capitalization. An investor cannot invest directly in an index.
Beta is a measure of risk representing how a security is expected to respond to general market movements. Smart beta represents an alternative and selection index-based methodology that seeks to outperform a benchmark or reduce portfolio risk, or both, in active or passive vehicles. Smart-beta funds may underperform cap-weighted benchmarks and increase portfolio risk.
The opinions expressed are those of John Feyerer as of Oct. 13, 2017, which are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
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