Morningstar's Ben Johnson considers the future of factor investors. Plus, two other top take-aways from this year's ETF conference.
By Ben Johnson, CFA | 11-08-17 | 06:00 AM | Email Article

A version of this article was published in the September 2017 issue of Morningstar ETFInvestor. Download a complimentary copy of Morningstar ETFInvestor by visiting the website.

Ben Johnson, CFA, is director of global exchange-traded fund research for Morningstar.

Looking back at the Morningstar ETF Conference, held earlier this fall, I’d like share with you my top three take-aways from the event. 

Factors, Factors, Factors
The topic of factor investing, strategic beta, smart beta, or whatever you choose to call it is unavoidable these days. The theme was threaded throughout our conference agenda, as it is an area where inves­tors continue to have more questions than answers. We were fortunate to have a pair of the industry’s foremost experts on hand to share their thoughts: BlackRock’s Andrew Ang and Research Affiliates’ Chris Brightman.

Ang literally wrote the book on factor investing. [1] In his presentation, he emphasized that factors are nothing new. The first widely recognized reference to value investing was made in Benjamin Graham and David L. Dodd’s “Security Analysis,” first published in 1934. The idea that buying cheap stocks is generally a winning strategy is decades old. The same can be said for momentum, which was effectively captured in Edwin Lefevre’s “Reminiscences of a Stock Operator,” published in 1923.

What’s new about factor investing, per Ang, is the manner in which investors can gain access to factors. Today, there are 661 ETFs that Morningstar includes in its definition of strategic beta. These funds seek to exploit one or more factors in an attempt to improve returns relative to a broad market-cap-weighted index, reduce risk, or some combination of the two. Mean­ingful advances in information technology, academic research, and investment technology have laid the foundation for the flourishing of factor funds. So although factors themselves are not new, the fact that investors can obtain factor exposure via a low-cost, transparent, tax-efficient, ETF is still a very fresh phenomenon.

But if factors’ popularity has surged and they are now more readily investable than ever, what’s to say that they will persist as more investors seek to exploit them? Ang argued that a combination of rewarded risks, structural impediments, and behavioral biases explain factors’ historical return premiums. His opinion is that many of these drivers will stand the test of time, particularly those that are economically intuitive (value) and are rooted in ages-old patterns of investor behavior (momentum).

Research Affiliates’ Brightman cautioned that investors may become overly enamored with these shiny new toys. In his presentation, he highlighted some of the potential pitfalls investors face when using factor funds. The first has to do with valuations. Factors, much like asset classes, will experience regular cycles of relative out- and underperformance. Thus, investors must be cognizant of the value of value, the momentum of momentum, the value of momentum, and the momentum of value. This was a point emphasized by Ang as well.

If these factors have generally delivered long-term excess returns, why should investors care about these short-term cycles? As I’ve emphasized time and again in these pages, understanding that factors are cyclical is crucial, as it will foster better behavior. Factor timing is folly. But we have seen regular examples of investors attempting to time their factor bets, to unimpressive results.

Brightman also underscored the importance of approaching new factor funds with a healthy dose of skepticism. Many new factor ETFs have been launched in recent years that track indexes created for the express purpose of being the foundation for a new fund. These indexes are often the product of a collab­orative effort between the ETF sponsor and an index provider. Their back-tested performance will invariably be appealing. Their real-world results, as recently documented by Brightman’s colleagues, [2] have been mixed at best. Brightman quipped that it’s almost as if there is something about filing for an ETF that makes its index stop outperforming. As I shared in “Every­thing You Need to Know About Strategic-Beta ETFs” in the March 2016 issue of Morningstar ETFInvestor, back-testing is to strategic-beta ETFs as incubation is to active funds. Bad back-tests never see the light of day. So be careful not to rely on simulated perfor­mance when choosing these funds.

My Take-Away
Strategic beta is the new active. In many ways it is an improvement upon the “old” active. These funds have lower fees, their processes are more systematic and transparent, there is no key-person risk, and—in the case of strategic-beta ETFs—they are far more tax-efficient relative to actively managed mutual funds. But they are still, for all intents and purposes, actively managed funds. Some will beat the “market,” others won’t. Framing strategic beta as a new form of active security selection and portfolio construction should help investors to approach these funds with eyes wide open.

The Changing Nature of Work
Joe Davis, Vanguard’s global chief economist, deliv­ered this year’s keynote. Davis shared three paradoxes that define the current state of the global economy and markets. Specifically, he stated we are living through a period marked by low inflation, but full employment; low growth, but high valuations; and low volatility, but high uncertainty. While low growth, in particular, would typically be indicative of a stagnating economy, Davis argues that under the surface the economy is being propelled forward by major technological advances.

Davis believes the effects of ongoing technological innovation won’t be adequately captured by tradi­tional statistics like gross domestic product growth, and their direction and pace certainly won’t be influ­enced by the factors most investors are fretting over, such as Fed policy. Rather, they will manifest in perceptible changes in productivity and prosperity. He shared an anecdote from his own family’s experi­ence, saying his grandmother could measure advances in her family’s well-being in increments of the things they could afford (the number of times they could serve meat at dinner in a week) and the opportunities available to them (for example, the fact that they could afford post-secondary education for their children).

The title of Davis’ presentation was “The Trend That Will Define Our Lifetime.” According to him, the trend that will define our lifetime is the changing nature of work. The interplay between human capital and technology will continue to evolve. Though many headlines paint a grim picture of our prospects, as humans forfeit more tasks to machines, Davis’ view is more sanguine. He believes that as more-mundane tasks are tackled by technology, we will allocate more of our time to those tasks that are advanced and uniquely human. In doing so, we will have to further hone our ability to think creatively, to embrace and learn to leverage technology, and to bolster our emotional intelligence in order to better relate to others and build and manage teams. Lifelong learning will also become the norm. Davis shared that he himself had enrolled in a handful of online courses recently to continue to bolster his skill set.

Davis stressed that this transition will not be painless. He estimates that up to 20% of the jobs that exist today could be eliminated by technology. But over the longer term he expects these losses would be more than recouped as new jobs related to developing and leveraging new technologies fill the void.

This tech-led transition could give rise to four new paradoxes. More automation could actually result in labor shortages. As the current workforce ages and aggregate demand remains stable, fewer workers and solid demand could actually offset any job losses stemming from automation. The second potential paradox is a market where labor is in short supply with low inflation. While labor shortages could result in wage pressure, further advances in technology will likely have an opposing effect on prices as the cost of technology declines. The third paradox is a pairing of low inflation and higher real interest rates. This scenario could very well arise in the event of steady productivity gains, said Davis. The fourth and final paradox is the juxtaposition of higher real rates and lower short-term market returns. Davis believes there is more risk in the stock market than fixed-income markets today as equity valuations are stretched and further interest-rate increases look to be on hold for the time being.

My Take-Away
Embrace technology. Never stop learning. I admittedly have Luddite tendencies that have likely impeded my personal and professional growth at times. Rather than shunning new technology, we should embrace it, especially if we can leverage it in ways that help us to continue to learn and build our skill sets (online courses are a perfect example). As our final general session speaker, PIMCO’s Jamil Baz, shared, our biggest asset is the one between our ears: our human capital.

We Are Not “Econs”
Our luncheon keynote this year was an engaging conversation between Ritholtz Wealth Management’s Barry Ritholtz and (since newly minted Nobel Laureate) Richard Thaler, the Charles R. Walgreen Distinguished Service Professor of behav­ioral science and economics at the University of Chicago. Thaler has spent decades debunking the notion that we can truly be rational economic actors, or “econs,” as he is fond of saying. It is perhaps not surprising that his field of study, behavioral finance, has been viewed as a form of misbehavior in and of itself by many of his peers who advocate more-tradi­tional models of economics that assume that we are econs. In Thaler’s mind behavioral economics is messy, while traditional economics is “precisely wrong.”

During his career, Thaler has collected ample evidence to support his case that econs, like the most widely recognized embodiment of logic in pop culture, Mr. Spock, are fictional characters. This body of evidence includes bubbles and bursts, naïve diversification, and our tendency to prioritize paying down large debts over those that have greater interest rates. All of these bits of evidence reflect the fact that our brains have been hardwired to prioritize survival and procreation and not necessarily to make cool and clear-eyed deci­sions about our finances and investments.

Are we in a bubble today? Per Thaler, “We all should be worried about high prices and infinitesimal vola­tility.” He added, “Given today’s news, that’s hard to understand. I wake up every morning, read the news­paper, and get scared.”

My Take-Away
We are our own worst enemies. In my mind, control­ling our own bad behavior is the biggest barrier to living long and prospering.

[1] Ang, A. 2014. “Asset Management: A Systematic Approach to Factor Investing.” (Oxford Univ. Press).

[2] Li, F., & West, J. 2017. “Live From Newport Beach. It’s Smart Beta!” 


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