This week, on Sept. 22-23, hundreds of advisors will descend on New York City for the inaugural Inside Smart Beta conference, the world’s largest gathering of smart-beta investors. Among the keynote speakers is Andrew Ang, head of factor investing strategies at BlackRock, and former chair of the Finance and Economics Division at Columbia Business School. In anticipation of the conference, Inside ETFs CEO Matt Hougan sat down with Dr. Ang to discuss the biggest questions facing smart-beta investors today.
Inside ETFs: Next week, you’ll join hundreds of investors at the inaugural Inside Smart Beta conference to deliver a keynote address. What will you be covering in your talk?
Andrew Ang: I’d like to talk about the next frontier in factor investing. ETFs have been a very important and efficient delivery mechanism for factor strategies, and have brought factors to the fore. But now I want to talk about putting those ETFs to work throughout the entire portfolio, and not just in equities.
Inside ETFs: You mean like fixed income? What are “factors” in fixed income, and what are the drivers that make them work?
Ang: The two main factors in fixed income are duration and credit. Those two explain close to 90-95% of all returns in fixed income. So the first thing that we might want to do to create fixed-income smart-beta strategies would to look at deliberate tilts toward rates and spreads. Then you would look at styles, because just like equities, there are different styles of fixed-income investing: momentum, low vol, etc.
Inside ETFs: Low-volatility fixed income?
Ang: Absolutely. In equities, we harvest min vol by selecting stocks with lower risk (as measured by volatility) but the same returns as the market, so that on a risk-adjusted basis, the returns are higher. In fixed income, the measure of risk is duration or maturity, and bonds with maturities that are shorter (two to five years) tend to have higher risk-adjusted returns than bonds on the long end of the yield curve.
Just like in equities, there are structural and behavioral reasons for the low-vol premium in fixed income. Many fixed-income investors have long-term liabilities they need to meet. They can’t take on leverage, so the only way to meet those liabilities is to take on very long duration. That pushes down yields and pushes up prices, while underweighting short maturity bonds.
Inside ETFs: Let’s take a step back—why are factors so popular now?
Ang: What’s new is not so much the building blocks themselves—we’ve known about value investing for a very long time; we’ve known about duration and credit in fixed income for a very long time; we’ve known about trend or momentum investing for a very long time. What’s new and is driving the excitement is the empowerment to access those building blocks efficiently via ETFs.
It’s very similar to my phone. If I look at the applications on my phone, they’re familiar. We’ve had maps for years; we’ve had calendars for years. But what’s new about my phone is the application and delivery of those applications.
That’s the same thing with factor-based ETFs. We have known about our investment goals for a very long time—saving for retirement or searching for steady income and so on—and we have known about factors for a long time.
But we can now meet those goals much more efficiently thanks to ETFs. We can, say, search for momentum across thousands of securities in a way we couldn’t before. We can do the same for value investing. And then we can deliver those exposures transparently and cheaply.
Inside ETFs: Now that it’s so easy, don’t you worry about people piling into specific factors and them becoming overcrowded?
Ang: We do think about that, but we believe the capacity in most smart-beta strategies is very large. In fact, we just published a paper on that, and I’ll give you an example.
Min vol is one of the smart-beta strategies that has enjoyed significant inflows this year. But the money allocated to min vol even during this period is tiny in the context of ETFs as a whole or within the context of active management.
If you look at the constituent holdings of the S&P 500, min-vol funds hold far less than 1% (0.2%, in fact) of the underlying holdings. That is a tiny fraction by any measure.
Another way to look at capacity is to … compare min-vol exposures to active funds. We can estimate the factor loadings of active funds in the U.S., and we know that active funds are quite short minimum-volatility exposure.
After all, many funds are constrained, but they want to beat benchmarks, so they take on high-risk exposure to try to do that. We estimate it would take around $600 billion for those active U.S. mutual funds to go to a neutral position.
Inside ETFs: One of the things I worry about is that smart beta will tempt people to time the markets, and there’ll be a gap between the investor return and the fund-level return. Will smart-beta funds do more harm than good?
Ang: The No. 1 problem for investors—both institutional and retail—is that they don’t hold for the long run. Pensions, endowments, hedge funds, it doesn’t matter: investors don’t hold for the long run.
I have some concerns that smart-beta strategies like min vol, which have done well recently, could have poor investor behavior. Investors should not be in min vol if they want to beat the market. You should be in min vol if you want to reduce your risk.
Investors who understand this are less likely to make timing mistakes. Understanding the purpose of your investments helps you stay the course, whether that’s for smart beta, factor investing or anything else.
Inside ETFs: How should investors choose among all the different factor ETFs out there?
Ang: We count 900+ smart-beta ETFs right now, and how to choose among them is a great question. I think there are really three areas people should focus on.
First, construction really matters. Different signals to signal cheapness are not the same, and the ways you construct portfolios are not the same between competing ETFs. You have to do as much due diligence with smart-beta ETFs as you did with active managers, just in a different way.
The second is purpose. You can have a great rule to generate strong returns, but unless it has a specific purpose in mind, you’re lost. Are you running a marathon or a sprint? What actual outcome do you want to meet? You have to answer those questions before you evaluate the fund.
And finally, fees matter too.
Inside ETFs: Let’s get more specific. Imagine I want to choose a multifactor ETF. How do I decide who has the right factor and who has constructed their portfolios correctly?
Ang: Start with diversification. You don’t want just one or two factors; you should look for a diversified approach. And within that, there are two approaches.
The first is that you combine factors from a top-down approach. For instance, you might construct an equal-weighted combination of a couple of different factors. The advantage of this approach is that it’s very simple.
Unfortunately, it’s possible for factors to cancel each other out. You might have a security that is really strong on momentum, but negative on value. If you equal-weight that with a security that is high on value but negative on momentum, they might offset each other.
The other approach is to build from the bottom up. You build a list of attributes you want and you assemble a team of securities to fit the bill. That’s got lots of advantages, but it’s harder to communicate and harder to understand.
Inside ETFs: It seems like smart-beta strategies are intruding on all aspects of what used to be active management. Where does active management go from here?
Ang: You have to answer this from two perspectives: first, from the active manager, and secondly, from the consumer.
The active manager is trying to compete with one hand tied behind his back. Currently, very few active managers explicitly place bets on factors, and they should. We should talk about factor rotation the same way we talk about country rotation and sector rotation and the like. We’re going to see a big pickup of factor strategies from an active manager perspective.
From the consumer, the great thing about smart beta and ETFs is that they provide low-cost, broad-based exposure to factor-driven strategies. If there are components of active management that can be done at low cost, then that’s absolutely how they should be done—to the benefit of all investors.