Ang: Factors As An Evolution

Ang: Factors As An Evolution

Moving beyond style boxes to another paradigm.

Reviewed by: Heather Bell
Edited by: Heather Bell

Andre AngAndrew Ang heads up BlackRock’s factor-based strategies group. He recently posted a blog, “The Five W’s Of Style Factors,” about the key questions to consider when looking at factors. In it, he discusses how factor analysis represents an evolution beyond the Morningstar style boxes that dominated the investment conversation for so many years. He spoke with in more depth about some of the points he made. There’s so much talk about the factor zoo, where there's hundreds of factors, but BlackRock has it narrowed down to just five—value, momentum, quality, size and minimum volatility. How that list was reached?

Andrew Ang: The first, most important, criterion is there has to be a compelling economic rationale. Are these [factors] generating returns through a reward for bearing risk? Do they arise from structural impediments, or investors' behavioral bias? This also gives us confidence that these factors, even though they've been around for a long time—that's our second checklist item—are going to be there for a long time to come.

The third checklist point is there has to be a differentiating source of returns, in particular, especially to plain-vanilla stocks and bonds, and ideally, the factors should have low correlations relative to each other.

The final one is a particular choice we've taken at BlackRock but that is not universal: We want to provide low cost to our investors. Therefore, these factors have to be scalable.

Once you take these four criteria and you pass potentially dozens or sometimes hundreds of factors through them, there is only a handful left, and they're the ones you mentioned. One of the big arguments I've seen against multifactor ETFs is that they're a less efficient way to get broad-market exposure, because once you add in all the different factors, it just becomes a muddle. How can investors avoid this outcome?

Ang: As of the end of September, there are 198 multifactor ETFs, and they're not all created the same.

There are some for which I think your critique is extremely valid, where if you're not careful in adding together these factors, you’re going to come out with the market. That's the outcome you don't want.

If you want to design an intelligent multifactor smart-beta offering, what you need is stocks that are cheap, trending and high quality. An inferior approach would cause some of these factor exposures to cancel each other out.

A bottom-up approach assesses each different stock on these criteria—is it cheap, is it trending, does it have quality earnings, is the stock small and more nimble—and you assess all of those individually.

One way to look at this is if you were to construct a fantasy sports team. In baseball, you really want people who are all-rounders, the utility player. To do that, you have to look at each individual stock and build up the portfolio from there. If you've got talent at hitting the ball out of the ballpark, that could be value, and that would be really great.

And you might have another skill like being able to catch a ball; that might be momentum. But what you really want is the guy who can hit, catch, run and field. You want the all-rounder. To make sure you collect all of those skills, you should be looking at a bottom-up approach and assessing each individual player. How often do you end up with these all-rounder stocks?

Ang: We believe you can look at just over 100 stocks, compared to a broad market benchmark, which might contain three to four times that. You’re able to construct a portfolio where you're able to get these multiple factor exposures in a well-balanced portfolio that retains the same sort of sector characteristics as the broad market. How can investors use factors in their portfolios?

Ang: We see factors being used by investors in three main ways. The first is to complement an existing portfolio, often of traditional active managers, but they might only have certain factor exposures, often value or momentum.

It's probably most appropriate to do some of that with single-factor smart-beta ETFs. That allows you to directly target factors you might not have in your portfolio today.

Another application is to find the most efficient way of investing. You might have some traditional active funds that just give you static factor exposures, and you're able to get that exposure in a transparent, lower-cost, more tax-efficient vehicle: a smart-beta ETF.

If you're looking at replacing a market-cap index position to either enhance your return or reduce your risk, then again, there are some particular combinations of factors that would be more appropriate.

So for a balanced type of approach, we might hold a multifactor fund. If we want to reduce our risk, we might shift toward minimum-volatility strategies. That's a particular outcome, and we're meeting that outcome again with appropriate factor combinations.

In the third type of application, you might want to express views. Just as some investors might rotate through sectors, countries or asset classes, we've also seen investors start to do the same thing in factors. There, I think it might be appropriate to start with a balanced/multifactor combination, and around that, potentially under- and overweight certain factors that are attractive and unattractive, respectively, at certain points in the business cycle. In your blog, you talk about upgrading style box holdings. How does the factor approach improve on the style box approach? And what would that transition look like in an investor's portfolio?

Ang: Style box is just a mainstay of the way investors look at portfolios. It plays an important part, because it allows investors to create a diversified portfolio. It also serves an important role in benchmarking. But there are really only a select number of factors, a very limited number. In that sort of framework, there's size and value.

We're almost entering 2018. We now have efficient smart-beta ETFs that give us access to more that just size and value. We have quality, and we have minimum volatility, and we can do this even in multiple asset classes.

Now we [can] go from that style box, with only just two factors, to a factor box that gives us a view on all the factors that might be relevant in an investor's portfolio. Within the style box, we might also look at, say, large-cap value, blend, and growth.

And we might be able to find more efficient representations of some of those style box categorizations. And that's that second application of factors we discussed earlier.

Yesterday's value and blend and growth are today's value factor, quality factor and momentum factor. And the factors are more efficient, low-cost, tax-efficient representations of some of those returns we used to get in a traditional Morningstar style box setting. They offer more fine-tuned exposure?

Ang: Yes. I think it's moving beyond just the two-factor lens to a more coherent, complete view of a portfolio. An analogy that may seem so foreign now to millennials and younger generations is black-and-white TV. It's not like [reality] is black and white. All of those colors are actually there, but we just had this view boiled down to two colors.

The richness though of that entire color spectrum is that all those colors were there, but we needed a new technology and a new TV to actually see all of that. That's where we're heading today. The wonderful view of the full-color spectrum will really enrich our investing experience.

Heather Bell is a former managing editor of She has also held editorial positions at Dow Jones Indexes and Lehman Brothers. Bell is a graduate of Dartmouth college and resides in the Denver area with her two dogs.