Research and Insights

Make Active Great Again

| 20 February 2018

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.

Top 10 General Equity Funds

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.

Average management fee

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.

Satrix Managers (RF) (Pty) Ltd (Satrix) a registered and approved Manager in Collective Investment Schemes in Securities and an authorised financial services provider in terms of the FAIS. Collective investment schemes are generally medium- to long-term investments. Unit Trusts and ETFs the investor essentially owns a “proportionate share” (in proportion to the participatory interest held in the fund) of the underlying investments held by the fund. With Unit Trusts, the investor holds participatory units issued by the fund while in the case of an ETF, the participatory interest, while issued by the fund, comprises a listed security traded on the stock exchange. ETFs are index tracking funds, registered as a Collective Investment and can be traded by any stockbroker on the stock exchange or via Investment Plans and online trading platforms. ETFs may incur additional costs due to it being listed on the JSE. Past performance is not necessarily a guide to future performance and the value of investments / units may go up or down. A schedule of fees and charges, and maximum commissions are available on the Minimum Disclosure Document or upon request from the Manager. Collective investments are traded at ruling prices and can engage in borrowing and scrip lending. Should the respective portfolio engage in scrip lending, the utility percentage and related counterparties can be viewed on the ETF Minimum Disclosure Document. The Manager does not provide any guarantee either with respect to the capital or the return of a portfolio. The index, the applicable tracking error and the portfolio performance relative to the index can be viewed on the ETF Minimum Disclosure Document and/or on the Satrix website. Performance is based on NAV to NAV calculations of the portfolio. Individual performance may differ to that of the portfolio as a result of initial fees, actual investment date, dividend withholding tax and income reinvestment date. The reinvestment of income is calculated based on actual distributed amount and factors such as payment date and reinvestment date must be considered. If the fund holds assets in foreign countries it could be exposed to the following risks regarding potential constraints on liquidity and the repatriation of funds: macro-economic, political, foreign exchange, tax, settlement and potential limitations on the availability of market information.
Share article:

Let us know your thoughts

Your email address will not be published. Required fields are marked *