What is factor based investing?

What is factor-based investing, and how does it actually work?

Factor-based investing, sometimes called smart beta or strategic beta, has attracted a lot of attention in recent years. But behind the jargon, what does it really mean for investors, and does it deliver on its promises?

In this video, Ben Johnson of Morningstar explains what factor-based investing is and why, in his view, it is best understood as a new form of active management. These index funds and exchange-traded funds track indexes we usually think of as passive, but they have an active bet against the market built into them. That bet typically takes the form of a tilt toward a particular factor, such as value (buying stocks that look cheap relative to their book value or earnings) or momentum (aiming to exploit the herding behaviour of investors as prices rise and fall).

Ben Johnson explains why patience and discipline matter more with factor-based investing than almost anything else. Because factors represent an active bet against the market, they go through periods of outperformance and periods of underperformance. Investors who chase performance, buying after a fund has done well and selling after it has done badly, tend to cancel out the very benefits they were seeking, creating a damaging gap between fund returns and the returns investors actually experience.

You'll also learn about the risk that factor investing becomes a victim of its own popularity. Ben Johnson describes a kind of observer effect, where investors crowding into a factor such as value can squeeze out the excess returns that factor was expected to deliver, at least until disappointed investors move on and the premium reappears.

The takeaway: factor-based investing can work, but only for those with the discipline to stick with a strategy through the full cycle. Without that patience, the potential benefits disappear.

Chapters / Key points

• What factor-based investing (smart beta / strategic beta) actually means
• Why Ben Johnson views it as a new form of active management
• How value and momentum factors work
• Why patience and discipline are essential with factor investing
• Why chasing performance creates a gap between fund and investor returns
• The risk of factors becoming victims of their own popularity
• The observer effect and how factor premiums can disappear and return

Transcript

What is 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.