When BlockRock’s Andrew Ang looks at factor investing and market cycles, he thinks there is nothing new under the sun. Factors and market cycles have always existed, he told an audience at the Morningstar ETF Conference. It’s just a matter of how to recognize them in an active manager’s performance stats and extract them into an investment vehicle.
Ang says more than 50% of an active manager's performance is due to "static" factors
“Smart beta was created by watching active managers," Morningstar Director of Global ETF Research Ben Johnson noted as he opened the conference.
This is the concept behind many smart beta and factor investing offerings and is driving a new method to build and optimize portfolios.
Ang is the man brought into BlackRock to help integrate a quantitative approach to BlackRock’s active management approach. He considers a large portion of the active manager's performance attribution as reproducing a market beta.
“Alpha exists, the issue is how to pay for it,” he said. Considering a 6% return from an active manager, 4% might be attributed to beta, which Ang termed as a “static” factors, whereby 1% might be attributed to factor timing and another 1% to manager stock selection, he reasoned.
Once the beta is extracted from an active manager's performance, the issue not so much eliminating the active manager, but understanding how they integrate. “Factor investing is a complement to active investing,” Ang said, noting that active managers are ideally combined in a portfolio with smart beta and stock indexes. It’s not an if/or decision but rather a portfolio integration question.
Ang considers market cycle in factor tilting and says they must have an economic rationale to be long-term viable
“Factors are to investments what nutrients are to food,” Ang said, outlining a strategy that defines a factor is defined and integrated into a portfolio.
He says factors much have an economic rationale in order to be long term successful. “Backtesting is not enough,” he said. A factor needs to be economically understandable to ensure it will last for decades.
He looks at value and momentum as the primary factors that have been proven through mountains of research and investment performance over time. Other major factors are based on stock volatility, quality, and size, for instance.
When building a portfolio, Ang recommends a degree of factor tilting.
Value and momentum are often negatively correlated. Value buys stocks when they are inexpensive, while momentum, by definition, buys when a price trend is already driving stocks higher. “Momentum is buying expensive stocks,” he said. The market environment establishing a trending environment can be not only defined by a moving average cross methodology but also the trend in fundamental measures of stock performance. Time horizon is important when benchmarking the market environment of momentum, and here Ang prefers a 6- to 12-month window.
Ang uses market signals for factor tilting and often applies multiple filters.
Valuation is important to consider, but this should be done through framing of other market signals such as relative strength and dispersion as well as where the business cycle is located.
At an early stage of an economic cycle, small cap stocks are often winners. Once a trend is established, and the economic trend has been established, momentum works. At the peak of cycle investors might want firms with stable earnings, lower leverage and perhaps low volatility.
Value companies can get hard hit in a downturn due to their overhead and fixed capital, which high-flying tech stocks, typically growth companies, usually have more human capital that can be easily re-distributed or eliminated than those stocks that have high physical overhead, which is often the case for value stocks.
“Investors need to squeeze as much blood out of a stone as possible,” Ang said, observing that since the advent of social media people are following the crowd, thinking with the consensus, more today than at any point in history. This presents an opportunity to actively manage factors.