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Enhancing returns with factors diversification
12/10/2018 9:47:43 PM
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By Fund Library News Wire  | Tuesday, September 25, 2018


 

 

By Jay Aizanman, Director, Desjardins Global Asset Management

Many people have become comfortable investing in basic index products as part of their investment regimen. And why not? Active managers often have difficulty beating their benchmarks, an issue which is only worsened by the fact that fees and operating costs compound the underperformance. By contrast, index investing is cheap, simple to understand given its transparency, and importantly, less prone to subjective human judgment by being rules based. No wonder investors have piled into passive investment products.1 Given increased familiarity and acceptance, investors have begun turning towards smart beta and factor indices to obtain better returns and manage risk more effectively. Why is that?

Traditional beta

Traditional indices, known as capitalization-weighted (cap-weighted) indices are derived by aggregating companies of a region or variety and giving them a weight in the index based upon their market capitalization share of the aggregate holdings. While simple, this construction methodology has proven somewhat inefficient given the concentration accorded to larger, growth-oriented companies which then holds hostage the index performance to these companies’ performance.

Smarter beta – the best of both worlds

What if there was a way to take advantage of some of the desired qualities of cap-weighted index investing while eliminating some of its known weaknesses? It appears that institutional investors have already embraced this utopic notion and have expanded upon research that really became popular in the 1990s, which indicated that identified certain fundamental characteristics that have exhibited excess returns above the market.

Consensus among experts2 seems to be that apart from the market exposure to capture the long-term equity market risk premium, six systematic factors are worthy of investor attention. These commonly accepted factors are:

* Low risk: Low volatility securities outperform highly volatile securities

* Size: Small securities outperform large securities

* Value: Securities that are cheap compared with their fundamental value outperform expensive securities.

* Momentum: Securities with strong price appreciation over the previous period tend to continue outperforming.

* Quality (commonly defined by profitability and investment): Enterprises with strong and growing profitability outperform those that are weakening.

Develop your core portfolio by factors diversification

We have seen it before. You implement a strategy at just the opportune time. It does well for a while. Then it starts not to “do well.” Like many active strategies, factor research2 has been pretty conclusive. While the systematic factors above add value over long periods, in the shorter term, specific systematic factors may exhibit variability, including periods of underperformance relative to the cap-weighted index.

Believe it or not, this may actually be a good thing.

The fact that some systematic factors demonstrate higher returns and higher volatility than the cap-weighted index while others have higher returns and lower volatility than the cap-weighted index opens the door to diversification of investment portfolios by systematic factors.

Investors have begun to take advantage of the fact that while some of the factors do well in a particular economic regime or market cycle and others do not, diversifying among factors (i.e., investing in a multifactor strategy) can actually lead to a smoother risk-return profile than the underlying cap-weighted index.

By implementing a multifactor portfolio, then, one could expect the following benefits:

* Lower volatility portfolio with higher Sharpe ratios (returns adjusted for risk).

* Higher information ratios (active returns adjusted for risk).

* Lower tracking errors (variability of return relative to the cap-weighted indices).

* Less dependency on a particular regime over the business cycle.

As institutional investors have been doing for over a decade, individual investors now have a way to capture the best of both worlds. Cheap, transparent, and rules-based investing that can be tilted, managed, and constructed to produce better returns per level of risk. As always, talk to your advisor before implementing this approach to investing.

1. According to Morningstar, in 2017 a total $692 billion flowed into passive funds, while almost $7 billion flowed out of actively managed funds in the U.S.

2. Source: scientificbeta.com

Jay Aizanman is an ETF specialist at Desjardins Global Asset Management. He is responsible for solutions that are tailored to the needs of Desjardins’ clients and partners. This article first appeared in the Spring 2018 issue of Your Guide to ETF Investing, published by Brights Roberts Inc. Reprinted with permission.

desjardinsfunds.com/etf

Disclaimer

© 2018 by Fund Library. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited.

The foregoing is for general information purposes only and is the opinion of the writer. Commissions and management fees may be associated with exchange-traded funds. Please read the prospectus before investing. Securities mentioned carry risk of loss, and no guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.

 
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