Make Active Great Again

A reflection on the rise of factor-based strategies

Many enthusiastic investors look forward to this time of year – be it with excitement or trepidation – so they can reflect on how their funds stacked up on performance-ranking tables over the prior year. The sterile obsession around 12 month performance notwithstanding, calendar years are neatly packaged time periods to look back on everything that went well, and everything that didn’t. Was my fund exposed to Steinhoff? Did I have enough Naspers? Was my portfolio hedged against the Rand? And ultimately… did I pick the right fund manager(s) to make those all-important calls and judiciously adjust my portfolio through the year to best take advantage of volatile markets?

Looking at the top of the General Equity category of unit trusts’ performance table, it appears all these questions are, sadly, irrelevant.

Why?

Because the top performing equity funds last year were completely dominated by funds that  are systematically run, i.e. their positioning is not determined by a traditional fund manager making fundamental calls, but rather by a disciplined rules-based approach selecting stocks to buy and sell based on a measurable investment characteristic. This approach is known as factor investing, which embeds the same characteristics that active managers employ in their investment process through well-known strategies such as Value, Momentum, Quality or Size, but are implemented in a passive  or rules-based approach. Importantly, our fundamental view is that these factors are fairly precise and intuitive drivers of risk and return in portfolios. Investors will ultimately benefit by viewing  their portfolio through a holistic ‘factor lens’, and making investment decisions based on this approach.

And just like that, it sounds as if we’re slipping into the depths of a tiring ‘active vs. passive’ debate… meh. In some respects, perhaps. The debate I want to have is not whether the average active manager can consistently outperform broad equity benchmarks – they can’t by the way.  But, have factor-based strategies (as represented by six out of the top ten performing General Equity funds in 2017) stuck their hands up as a legitimate investment proposition relative to traditional strategies?

Now, I’ll be the first to admit it. Any fund or strategy can end up being a top-performing fund over a short period, such as a year. Furthermore, even if a specific strategy has outperformed its peer group or the market consistently over a period of time, the strategy is always susceptible to suffering periods of substantial underperformance under certain market conditions, due to their specific cyclicality. What we typically advise clients is to blend different and uncorrelated factor strategies, as this produces more diversified portfolios, which mitigates the peculiarities associated with each individual factor.

But here’s what is interesting. If you look at this list of top-performing funds, they have no specific investment strategy in common. One would expect that over a particular period, a specific investment style would emerge as a clear winner. Last year, Quality, Momentum, and Dividend Yield featured as outperforming strategies, an almost unprecedented outcome. Moreover, the top-performing funds were predominantly all factor based (systematic, rules-based) suggesting that, not only is this approach style agnostic, but that 2017 saw an almost universal failure of traditional managers to outperform across all investment styles.

This outcome advances the debate around active vs. passive (meh again), to one that frames the discussion around ‘traditional active vs. factor-based active’. If factor-based active strategies continue to illustrate their efficacy and ability to produce superior risk-adjusted outcomes, clients will benefit via improved transparency, capacity, predictability of returns, and importantly, lower fees (see chart below).

On the point of investment fees, it is interesting to observe that the top 20% of General Equity funds in 2017 averaged 0.82% management fees, and 1.15% of TER (see chart below), with poorer performing groups of funds demanding high fee levels. Investment fees have certainly shown to be an arrow in the quiver of factor-based strategies, however the primary motivation should not be low fees, but to empower investors to build portfolios simply and efficiently.

Another constructive application of factor investing is performance benchmarking. An investor can now understand the value the active manager is adding beyond factor exposures, and particularly in relation to their fees charged, given that pure alpha is rare and more expensive. While many fund managers explicitly avoid boxing themselves into a style box, it remains important for a manager who exhibits an investment philosophy relating to Quality, that that manager be measured against a Quality factor-based strategy.

The rub here is that everyone’s definition of Quality (or any other factor) is different. Why should anyone accept, for example, Satrix’ version of factor definitions? This is true. Ultimately one needs to lean toward providers with transparent, intuitive and academically grounded factor definitions, providing a powerful way for investors to access tools for diversification, and also to unlock market-beating returns.

This way, factor-based or otherwise, we can truly make active great again.