How to succeed at factor-based investing [video]

Factor-based funds are becoming increasingly popular

    Factor-based investing is sometimes known as smart or strategic beta

    There is a great deal in the media about factor-based investing, sometimes known as smart or strategic beta. So, what exactly does it mean?

    Why is patience particularly important when it comes to factor-based investing?

    RP: Hello there. We’ve been hearing a great deal lately about factor-based investing, sometimes known as smart or strategic beta. So, what exactly does it mean? Here’s Ben Johnson from Morningstar.

    BJ: What we call strategic beta is really just a new form of active management. So, these index funds, these exchange-traded funds, are tracking indexes, which we generally think of as being passive, that actually have embedded within them, an active bet against the market. And that active bet typically takes the form of a bet on a particular factor. So, value for example: Investing in stocks that are trading at prices that are cheap relative to, let’s say, their book value or their earnings. Or momentum, a factor that looks to exploit the herding behaviour of investors that crowd in one direction or another as stock prices run up or as stock prices run down.

    RP: Patience is a virtue with all types of investing, but it’s especially important with factor-based investing. If you can’t stick to your strategy through thick and thin, you’ll cancel out the benefits of doing it in the first place.

    BJ: So this is by definition a form of active management and what we’ll see, by definition, is behaviour that is very much identical to what we’ve seen with active management on the part of investors. I’ve fully expected investors, in many cases to use these funds poorly, they will chase performance. They will buy after the funds have done well, they will sell them after they’ve done poorly and the result will be a gap between the returns that these funds produce and the actual returns that investors experience.So, factors, not unlike active management, represent a bet against the market. An active bet that, by definition, will experience periods in which it will outperform the broader market and periods where it will underperform the broader market. And one's ability to benefit from that active bet depends on having the discipline, the fortitude to stick with it through the entirety of that cycle, which can be difficult to do.

    RP: Factor-based funds are becoming increasingly popular. So is there a danger that they’ll become so popular that the premiums these factors are expected to deliver will disappear?

    BJ: So what you could very well see is a form of observer effect. Whereby people crowd into, let’s say the value factor, through one or multiple funds that set out to exploit that value factor. By doing so, they squeeze out any excess performance that might have existed in there. Now, ultimately, what I think you will see is that behaviour will take hold, that people are still people and that newly minted value investors will get fed up with market-like or subpar performance, they will go out of that fund or that factor as quickly as they entered it and value will magically reappear.

    RP: Thank you to Ben Johnson, and to you for watching. Goodbye.

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