MASTERCLASS: ETFs - December 2019
November 22, 2019
Remy Blaire: Welcome to Asset TV. This is your factor investing master class. Factor investing is an investment approach that involves targeting specific drivers of return across asset classes. The strategy can enhance diversification. I'm joined by Darby Nielsen, managing director of research equity and high income at Fidelity Investments, Lance Humphrey, executive director of global multi-asset and portfolio manager at USAA Asset Management Company and Raina Oberoi, executive director, head of equity solutions research for Americas at MSCI. Thank you so much for joining me today. Well, first and foremost, factors can be considered one of the foundations of investing. So, Darby, starting out with you, with a very fundamental question, Why factors?
Darby Nielson: Well, I think that there are several reasons to use factors in the investment process. I like to think of three different use cases in particular; one is to strategically gain exposure to factors, because there are some factors that over time, have added value over the rest of the market, added excess return. Factors like quality, factors like momentum, these have added value. So, a strategic exposure can be helpful because over time, some of these factors add value even if not all the time, is another thing I'd like to point out.
Darby Nielson: Secondly, is to adjust exposure in a portfolio for risk or portfolio construction purposes. Let's say you own a bunch of funds and then when you put them all together, you have some exposure to volatility or something, you can use low volatility as a factor to adjust that exposure, counterbalance that risk or that exposure. And then the third thing I would say is tactically gain exposure to certain factors depending on a view you might have. Depending on where we are in the business cycle, if you think you have a view on what factors are going to outperform or underperform, as I said, they can be cyclical in nature, the returns they outperform over time, but maybe not all the time. So, you can also use them tactically if you have a view. You can use a factor to implement that in your portfolio.
Remy Blaire: Well, I think you've touched on some of the most common factors. So, I want to bring the conversation over to you, Lance. Can you tell me about the differences between the different type of factors?
Lance Humphrey: Sure. Well, if we think back to the way people have thought about factors in the past, a lot of times it was around macro factors such as economic growth or inflation and how these types of things impact overall asset classes and the returns of overall asset classes. But their narrative has really shifted more towards style factors, where we're looking at what drives the cross section of returns or what drives the differences of returns throughout different asset classes. So, an example of that might be something like momentum, which is looking at stocks that have had positive trailing returns relative to stocks that have had weak trailing returns.
Lance Humphrey: And what we find is that oftentimes, there's premiums associated with these types of factors where again, historically we see stocks that have had that high momentum have outperformed stocks with lower momentum. And we've seen things in the value space or in quality as well.
Remy Blaire: And now that we've covered that, I will go to you, Raina. I want to ask you about the evolution that we've seen in factors now. Factors have been around for decades, so it's not a new investment process. So, tell us about what you've seen and how it's evolved.
Raina Oberoi: It's interesting that you mentioned that factors have been around forever, because there are still a lot of investors out there who actually think it is a relatively recent phenomenon. So yes, I totally agree with you that factors have been in the investment process for decades. So, if you think about it, the investment thesis or the academic intuition behind them hasn't really changed. They tend to have the same characteristics today that they had before. They obviously have economic rationale attached to them. Factors have a long-term premium attached to them.
Raina Oberoi: They are able to explain a certain portion of portfolio risk, they're implementable in the investment process. So, nothing is really changed. I think what has changed is the implementation of these factors in the investment process. Today they are rules based, transparent and a lot more accessible to the investor than they were back in the day.
Remy Blaire: And Raina, before I move away from you, why do you think there is this misconception that factors might be something relatively new?
Raina Oberoi: I think it is just the education. We've spent, I would say the last decade talking to clients about factors and the implementation of it and how it can be actually captured in a transparent, rules- based fashion. So, a lot of clients who were a little more sophisticated probably knew that factors are a part of the investment process. So, for example, if you think about a fundamental stock picker who's picking smaller cap stocks, another stock picker who thinks quality stocks are more important than his or her portfolio, they are all incorporating factors in their investment process. But I think the education of it was required for investors to actually understand that this is... it's the same thing, it's just now packaged in a different way.
Darby Nielson: Yeah, I would agree. I would just add that I think they've become... More in the news or in the media, people are talking about them more because easier to implement them as providers on our side. But it's also easier to implement them as investors because of the proliferation of smart beta, the launch of all these products, which really only started probably 10 or 12 years ago, even though Quantum have been doing them for decades. But I think of it as like, people are excited about AI nowadays, but these AI algorithms have been around for decades. It's just that now we have more data and more computing power, and so it's just easier to implement.
Remy Blaire: And indeed we continue to see more headlines that highlight factor investing very recently. Now, now that we've covered that, Lance, I wanted to turn it back to you. We know that investors have flocked to ETFs, track market cap weighted indexes, but we have to also keep in mind that when it comes to weighting individual constituents based on their total size, this can lead to problems. So, I want to ask you about this false sense of diversification that we oftentimes get. Can you give us insight into that?
Lance Humphrey: Sure. If you think about it, going back to the very beginning of when ETFs were initially launched, we found that most of the products were really focused on getting broad exposure to various markets, whether it was the S&P 500 or the MSEI emerging markets index or even individual sectors. Those tended to be market cap weighted because that was the intent of the product was to capture the overall market that it was targeting.
Lance Humphrey: But when we think about it, oftentimes, now we're trying to stop a different objective. As Darby just mentioned, investors are using these types of products, particularly ETFs to solve a lot of different portfolio objectives for their clients. And so, if we think about it, market cap weighted portfolios based on the size of the company can lead to some unintended consequences like you mentioned, where you can often buy markets that become incredibly concentrated in a market cap index. So, if we think of the S&P 500 today, the top five names make up almost 20% of that index. The top 50 make up 50% of the index.
Lance Humphrey: So even though it sounds as though you have 500 names in the portfolio, a lot of different stocks moving, it's really just a handful of names that are really going to drive the return of that particular portfolio. And it can get even more pronounced in more niche markets. So, if we think about, from a sector perspective, like energy, the energy sector has dozens of names within the index, but if you look at the ETFs that track that that are market cap weighted, you might get three names that account for more than 50% of the overall portfolio. So again, the question then becomes, well, how can we capture an overall market exposure, but do so in a more diversified way?
Lance Humphrey: So again, when we look at how we weight portfolios, it doesn't necessarily have to be by market capitalization. One simple way could be to equal weight all of the names in the portfolio. That's going to create more diversification, but one unintended consequence there may be that now the risky names are going to contribute more of the risk than the lower risk names. So, one way that we like to look at it is from a volatility-weighted or risk-weighted perspective, which essentially what that is it starts with an equal weight portfolio, and it takes the names that are lower risk and gives them a slightly higher weight, and names that are higher risk and give them a slightly lower weight.
Lance Humphrey: And what that does is really gives every stock in the portfolio of voice. It really allows every stock to have a balanced risk profile relative to the overall portfolio. And the last thing I'd mentioned is while that can work very well on broad market, it works very well also within individual niche allocations. So, for instance, if we were to want to buy a portfolio of let's say a hundred of the largest dividend paying stocks within the universe, by volatility weighting those, you can still maintain a very diversified risk profile.
Remy Blaire: And there are advisors watching this master class, I think those insights will be very helpful. Now, Darby, you work in the quant space, so you bring a very unique to this discussion and to this factor investing masterclass. So, could you tell me a little bit more about Fidelity's quant research capabilities?
Darby Nielson: Sure, yeah. Although I'd start by saying they may not admit it, but they're probably quants too [inaudible 00:09:08]. So, I guess I'd say Fidelity is traditionally thought of as a fundamental research company. And in many ways, we still are. We're still quite good at it, I would say. But we're known for... Over the years, we've had extraordinary investors like Peter Lynch, and even now we have Will Danoff and Steve Wymer. But, having said that, and essentially, we just talked about factors being around for decades, Fidelity has been doing quantitative research for decades. We hired our first quantitative analyst in 1965, I think, I found that if in the Fidelity archives. His job at the time was to figure out how to use the computer in the investment process, and that was the days when we probably had one computer and it filled the room.
Darby Nielson: But the point is we've been doing quant for decades. At this point, we're now up to probably a hundred quants across all the investment organizations, equity, fixed income, asset allocation. And then in my space, in equities in particular, we have a team of quants, and their job, their primary mission is to work with the portfolio managers and use factor models for idea and alpha generation and portfolio and risk analysis. That's really what our mission is for the team of quants in the equity group.
Darby Nielson: So over the years, we've built our own factor library, dozens of quantitative models, and all of it has been done, again, working with our fundamental counterparts because the way we're arranged is the quants in equity are assigned to the teams, they are embedded in the portfolio management teams. So, the small cap team has their own quant, emerging markets has their own quant, value has their own quant. You get the idea. And what's great about that partnership is that we can learn from the fundamental investors. It informs our quant process, and all of that has helped us build our quant capabilities over the years.
Darby Nielson: And then what's been great about that is for the last several years, we've been able to leverage that capability to launch our own factor products. So, we've launched her own suite of Fidelity factor ETFs, and it's all been leveraging the capabilities that we've built over the years, the quant capabilities within Fidelity.
Remy Blaire: Well, Darby, I think you really highlighted and emphasized the evolution that's been taking place over at Fidelity. And Raina, bringing it back to you, you did highlight how the process has evolved, but I didn't get to ask you why factors. So, can you give us an insight into why you think factor investing is important?
Raina Oberoi: Again, to sum up what everyone said here, I think these are systematic sources of return that had been grounded in academic research, and clients just have to figure out how to implement them in their portfolio. What is their use case, and what is the problem they're trying to solve? Are they trying to analyze the risk of their portfolio? Are they trying to understand what is the factor that will drive the overall performance of their portfolio? So, there are different use cases, but I think the investment thesis behind factors has remained and still remains.
Remy Blaire: And with any investment process, we have to talk about returns and performance. So, Lance, taking it back to you, it's no secret that the way you combine factors as well as the factors that you can select affect returns and performance. So, tell me a little bit about the combinations you think highlight the importance of objectives and give us a little bit of insight into different factors.
Lance Humphrey: Sure. Well, at the broadest sense, I really like to think about factors in terms of offense and defense, where... When I say offense, I mean there are certain factors that when we look historically at the research that we've talked about, they've tended to provide higher absolute total returns than the overall market. So, if your objective is to outperform the market over time, there's certain factors again, that are more offensive in nature that can help with that particular objective.
Lance Humphrey: Secondarily on the defensive side, there's factors such as minimum volatility investing, high dividend paying stocks, high quality stocks that tend to have more defensive characteristics. So, depending on the client's overall objective, you can use those factors in creative ways to help really hone in on overall portfolio risk. You also asked about combining factors, which is where things can get very interesting, where I'd mentioned on the offensive side, factors like value and momentum, we work over time, we find have had a historical premium associated with them, meaning they've outperformed the market over time. But they have done that individually with higher risk than the overall market.
Lance Humphrey: But if we look at the correlation benefit between the two, meaning that value and momentum tend to do well at different times in the economic cycle, so by combining two factors such as value and momentum together, you can actually take factors that have had higher returns and higher risk in the market and actually help bring that risk back in line by leaning on those correlation benefits. So again, I think it's important to understand the individual factor characteristics and how they can fit into a portfolio. But again, more importantly, when you start combining them, you can get some very interesting impacts.
Remy Blaire: Now, Raina, MSCI has been entrenched in the field of factor investing. So, could you please tell me how you've seen the process evolve?
Raina Oberoi: Sure. I would say I see two processes here that have evolved. One is, obviously, the world of investing, and then two is MSCI's role in that world of investing. So, if you think about the evolution in the world of investing, we started out with a very simple market cap based approach. That was then moved on to kind of style based investing where you took your entire universe and divided it half into value, half into growth. And then over time, investors realized that there are more systematic sources of return out there. Again, nothing new, all grounded in academic research, which we call factors today. And that is something which is becoming more and more prevalent and pronounced in the way investors are to look at their sources of risk and return.
Raina Oberoi: The second evolution path, I would say, is MSCI's role in this whole process. So, as you are aware, MSCI has been building factor models for 40 plus years to analyze sources of risk. From there, we went on to identifying factors that have had a long- term premium attached to them, and we've covered a few of them such as momentum, quality, value, et cetera. Now, we obviously had that, we had the backing of academic research. I think the next step that MSCI took was, how can we implement these factors in investible portfolios? And that's when the construction of these investible portfolios took off, which we call factor indexes today.
Remy Blaire: So Darby, you work with portfolio managers on alpha generation to assess risks. So, can you give us more insight and tell us how quant research is utilized at Fidelity in your process when working with portfolio managers?
Darby Nielson: Sure. I mentioned a moment ago how in the last several years we've been involved in designing new factor products, launching ETFs, which has been an exciting development, but it's really leveraging the expertise we've built over the years where our primary mission is working with the portfolio managers, where first and foremost, we're using quantitative models for idea generation. Using these factor models, working with the portfolio managers to identify new ideas that they can take a look at, particularly in the small cap space where there's just a lot of ideas to look at. We have a lot of portfolio managers that look at those.
Darby Nielson: But we also do ongoing research on new factors. We get questions from portfolio managers all the time, "What factors work in my space or in my sector?" Over the years, we've built dozens of industry and sector-specific factor models for identifying new ideas. And one specific example I would highlight is a particular portfolio manager, an international PM who works with this embedded quan, describes this process as value plus quality. Well, we were able to do with him is work to build a new model. How do you define value? How do you define quality? Build a new model that captures his process, so that he can now use that model to identify new ideas, but also monitor his exposures and make sure he's doing what he says he's doing.
Darby Nielson: Because that's another key area, really. I talked about factor models for idea generation, but factor models to understand exposures, understand risks across the industry. Quants have been using those models for several years, as you just mentioned. MSCI [inaudible 00:17:08], I would acknowledge you guys are very famous for that.
Raina Oberoi: Thank you.
Darby Nielson: So risk models for portfolio construction, we use that as well, all factor based. Because I'd say... That's what we do, we provide factor-based insights to our portfolio managers to help them with either alpha and idea generation or portfolio construction and risk management.
Remy Blaire: And since we were talking about factor investing as well as portfolio construction, we can't have a discussion without mentioning smart beta. So, could you tell us how you explain the difference between factor investing in smart beta?
Darby Nielson: Yeah. It's a tricky one because to me, it's pretty much the same thing. I think of factor investing in smart as pretty much the same. But at back way up, we talked about academic research to say that when I think about this particular question, how to distinguish them. The first factor was just plain old beta from the capital asset pricing model. 50 years ago, we discovered the first beta that was market sensitivity and that came from the capital asset pricing model. But I would call that the very first factor.
Darby Nielson: Over the years, as you said, we've discovered many other factors. Thank you Fama and French, because there's many factors academics and practitioners have discovered over the years. You could argue that the term smart beta came about because we discovered that some of these factors, as we've discussed, actually adds an excess return over time and that's why they're smart factors or smart beta. So maybe you could split hairs and say that investing in any factor, even if it doesn't add alpha is factor investing, but those that add alpha is smart beta. But I would say to me, it's pretty much all the same thing. I'm curious what you guys think.
Lance Humphrey: One thing I'll add on that, and I completely agree with Darby, that really as practitioners in the field, the two terms are used very interchangeably, whether it's smart beta, strategic beta factor investing. But again, expanding on what Darby mentioned, in the academic space, a lot of times factors are expressed differently than what we would typically express a smart beta portfolio. And what I mean by that is a lot of the research that we've referenced today is done in a way where it's a long short portfolio that essentially takes a number of stocks, let's say the top 20% on the value, and goes along those 20%, and then will take the 20% of the worst stocks on that given metric and go short for equal dollar amounts. And so, these portfolios are essentially long short portfolios sorted on the given factor, value, momentum or quality.
Lance Humphrey: When we look at the products in the marketplace today that are often referred to as smart beta, it's generally expressing the long side of that particular factor portfolio, meaning there's many products today that might focus on the top 20% of value stocks within the universe. And I think the main implication for advisors and investors on the distinction is really that in that long away format, you are going to get just traditional market beta as a large portion of your portfolio. So, if you think about what drives the return of a factor portfolio that's expressed in long only, the direction of the market is going to have a large impact on the returns of that. And then the factor that's added on top of that will then adjust it from there.
Remy Blaire: I think it's very helpful to hear about that distinction, especially for advisors that might be in the viewing audience as well as other viewers. Now, Raina, I want to hear about your take on market events and how you think factors play a role in terms of returns as well as performance.
Raina Oberoi: Sure. So just like any investment strategy, factor based strategies also are impacted by market events and market macro regimes. So, I think it's extremely important to discuss this because anyone is looking at these strategies or considering them or already evaluating them should be evaluating them in the light of these different regimes. Are you looking at different macro regimes? Are you looking at different industry regimes? What happens to your portfolio then? Are you looking at the impact of different ball regimes in your portfolio?
Raina Oberoi: And we at MSCI have obviously done a lot of research around factors, but specifically on how these different regimes and these different macro inputs can impact your factor portfolios. And coming to that, there is obviously a lot of cyclicality that we've seen among factors depending on what you're looking at. Volatility might tell you something, and the interest rate environments might tell you something different. And the overall sentiment might tell you something different. So, you want to take all of that into account.
Raina Oberoi: I use an example of, sometimes up investors are like, "Well..." We feel like it's a risk of environment, which factors should we look at? Well, in general, if you think about it, there are defensive factors and pro-cyclical factors. So, a factor like quality is in general considered defensive factor and tends to do well where investors are cautious about the economic outlook. On the other hand, smaller cap companies tend to do better when things are going well and they're able to manage their balance sheets better. So, there is a cyclicality associated with factors which again, we touched on this a little earlier, there is a lot of value in combining these factors because of the cyclicality associated with them and the diversification that combining factors actually brings to your portfolio.
Darby Nielson: Yeah, I would just jump in and say... I think you guys both talked about the diversification benefits from combining factors, which is critical. But I think you'd probably agree what you just talked about is kind of what I mentioned at the start, that your understanding how factors do in different environments is why you can use factors. Potentially, if you have a view on where you are in the cycle or where you think rates your volatility is going to go, that was that third use case I think you can think about using factors for.
Remy Blaire: And indeed this is the time of year when a lot of firms are issuing their midterm outlook. And I know that MSCI has done research regarding market volatility as well as the fed outlook effecting factors. But just opening the floor up, do you have any insight into how volatility as well as the current fed outlook has affected your outlook?
Raina Oberoi: Sure. So, the research in volatility, essentially what it did was it divided regimes into high ball regimes and low-ball regimes. And it's intuitive that we found that factors that are pro-cyclical, like for example low size and value actually do get impacted when it's a high ball environment. And investors are more cautious, so they tend to go to more of the defensive factor strategies. And so, in low ball environments, you have these same strategies that tend to do better because there is less caution out there in the market.
Raina Oberoi: Momentum was the only factor that in general was agnostic to the different ball regimes that we found over time. And I would say the interest rates, again, the research on that was also quite telling. For example, when rates are rising, it's always hard for smaller cap companies who could be more levered for them to manage the balance sheets, so they get more impacted. It's harder for them to raise capital in times like this. So, then you would see some sort of underperformance coming in there.
Raina Oberoi: And then in similar vein, quality companies that tend to have low leverage tend to do better when the same environment plays out. So again, there are a lot of nuances. Obviously, we cannot make blanket statements across the board about how these different factors would behave, but at least, in a sense, having some guidance around what could potentially happen always helps.
Darby Nielson: Yeah. Continuing on that thought, we've also done a lot of work on interest rate changes and how that affects factors. I think you talked about quality a moment ago and small caps a moment ago. But we've also found in rising rate environments, that tends to be bad for the dividend factor. Because if the rates are going up, the bonds become more attractive. It's not as good for equity, dividend paying stocks, and it tends to not be favorable for the dividend factor. And at the same time, it's not good for the low vol factor. And I think intuitively, it's because if rates are going up, bonds are going down, which means you're in a risk on environment and equities are going up, and low vol tends to underperform in those rising rate environments.
Darby Nielson: So, we've done a lot of work on that space as well. It's what's happened on average, as you said. It's hard to tell what's really going to happen, but it's an interesting research.
Remy Blaire: And indeed, we don't have a crystal ball, so we don't know what's going to happen. But this is the time of year that firms are issuing their midyear outlook, so I think it's very helpful to know how these broader fundamentals, monetary policy will affect factor investing. Now, bringing the discussion back to returns and performance, Lance, I want to ask about evaluating multifactor investing. Could you tell me about the five Cs?
Lance Humphrey: Sure. Well, if you think about the way practitioners have evaluated really any active manager, they often use what people will call the four Ps, which is people, process, philosophy and performance. But as a user of ETFs today, we thought that we really need to come up with a different framework, particularly for factor based products, which we call the five Cs, which is combination, concentration, construction constraints and craftsmanship. And really quickly going through them, I would argue that really, we've talked a lot about factors today and which factors might work, when and which factors are good and not good. But I would argue that oftentimes, this topic gets overlooked, which can really drive even more of the portfolio characteristics in the short term.
Lance Humphrey: And so again, going through those, if we think about the combination, we have talked about that which is if we're going to put one or more factors together in a portfolio, how do we want to combine those factors? There's a couple of ways you could do it. Number one, you could buy the factors independently of one another and combine them in a portfolio, meaning you buy a value portfolio and a momentum portfolio, then combine those at 50%, let's say, each.
Lance Humphrey: An alternative way of doing that would be to do it from a bottom up perspective, meaning you're looking for stocks that share characteristics of those two factors, and then building one portfolio. So again, the choice of that can make a big difference in the portfolio. Going down the line, if we look at the concentration, how many stocks are you choosing? Is it the top decile, the top quintile, top 50%? Can make a difference. The third one, and arguably maybe the most important would be the construction or the weighting scheme, which we did talk about earlier.
Lance Humphrey: So once you've selected the stocks that you want to purchase, how do you weight them in a portfolio? Do you put them based on their market capitalization or their size? Do you equal weight or do you volatility weight? And then lastly, constraints and craftsmanship, which are really on the edges. Are you building the portfolio sector neutral or region neutral? Are you doing things to reduce turnover or to improve liquidity? So, all those things are very important.
Lance Humphrey: And to give you just an example, if we think back to 2018, last year, and we will get the momentum factor, for example, there's over 18 funds within the Morningstar universe that target the momentum factor as the primary factor in the US. And if we look at that, if we look at the, let's say the academic version of momentum, it technically outperformed in 2018. But out of those 18 products that are all targeting the momentum factor, 14 of those products underperformed the market. And again, the reason being because they all weight the stocks differently within the portfolio. So, the ones that tended to do well were ones that focused on momentum stocks and weighted them based on their market capitalization.
Lance Humphrey: However, if you did the same algorithm or the same portfolio construction where you pick those same stocks but you equally weighted them in 2018, you would have underperformed in the market by a decent margin. So again, those are a couple of examples of why these nuances within the portfolio construction can become very important for investors.
Remy Blaire: And Lance, I'm glad you brought up the five Cs. Raina, as well as Darby, you have a both touched upon multifactor investing, but what's your take and what do you make of these five Cs?
Darby Nielson: Oh, the five Cs? Actually, I was going to jump in, but I keep jumping in. To say that I... It resonates with me a lot because I think there's a myth out there that all factor products are the same or that they're a commodity. You can take the same category of momentum or value or quality, whatever, and get very different returns based on the factor selection and the portfolio construction decisions. So, to me, I think it resonates a lot. I think that investors need to do due diligence on factor products in the same way they would an active product because they're not all the same, the decisions made in their construction can really make a difference in the returns.
Raina Oberoi: Yeah, I would like to add there. We see it day in and day out. At MSCI, we obviously have our standard factor indexes which use these standard methodologies. But we have a huge custom index business, and it's... Every single time we have a conversation with a client, they will tell us that we like what your certain methodology does, but we also are trying to solve this problem. So, at the end of the day, every client is trying to solve a different problem, and the solution is not the same. It's a tweak of the standard offering. So, some clients are okay with more concentration, some clients are okay with less liquidity. They can manage the liquidity at their end. Some clients are more interested in the most pronounced factor exposure they didn't get out of the portfolio.
Raina Oberoi: So it really depends on what investment problem that you're trying to solve and as a result, it's really hard to say that all of them are the same. We get this question a lot from our clients on, what is the exact capacity of a value strategy? Can you put a number to that? And it's hard to put a number to that because every value strategy is not constructed in the same fashion.
Remy Blaire: Raina, I think you bring up a lot of important points, especially depending on what clients are looking for. And Darby, you mentioned due diligence. So, when it comes to this type of investment, what type of due diligence should be enacted?
Darby Nielson: I think Lance hit on a lot of it. The first thing you need to take a peek at is, what are the actual factors that go into it? Because there's a lot of different ways you can define value as an example. Is it just price to book or is it a variety of different factors? We believe that a variety of different multiples used to define value is the way to go. But if you use one or if you use four, you can get very different returns. So, factor selection is very important.
Darby Nielson: And then from there, there's the portfolio construction decisions, and that's what lance talked about, the constraints on sectors or size or positioning. We actually feel that putting constraints on those, putting some constraints around sector bets or how big the individual bets can get, reducing the idiosyncratic risk. It is very important to reduce the unintended risks and focus on the exposure that you really want. So, in our ETFs, that was a major objective, to focus on that target exposure and reduce the other unintended risks. But that's all about portfolio construction. So, you have to evaluate the factors that go into it, you have to evaluate the portfolio construction, sectors, size, security level bets.
Darby Nielson: And then I think from there you want to evaluate the ETF provider. Is this an ETF provider that has experience in quantitative techniques, quantitative tools, building these types of products? All of which, to me, would be part of the due diligence process. Hopefully, I hit most of what's in the Cs there.
Lance Humphrey: Yeah. And one thing I'll add, a common refrain that I hear with these factors is understand what's under the hood. And I do think that's important. I would take it one step further though, because to give you an example, if we're talking about a car, underneath the hood, I'll be the first to admit I know very little about the mechanics of a car. And so, someone might say, "Well, you need to know what type of transmission you have and how many liters is the engine." And I might know that, I might look under the hood and understand that information, but I don't know what that really means to the end result of the vehicle. Does that mean I lose stability? Does that mean I can go faster in a straight line?
Lance Humphrey: So I think it's important not only to understand those aspects, but then understand, what does that mean to the end result of the portfolio. So, if we talk about sector constraints for example, I think it's important to understand that it is constraining the portfolio, which for many investors is what they're looking to accomplish because they may say, "I want to target the value factor, but I don't want to have then sectors driving some of the residual return to the portfolio."
Lance Humphrey: However, there's times where by allowing it to be unconstrained, the returns might be higher to that factor in a more pure sense. So again, there's not necessarily a right or wrong answer to any of these types of things, but they can cause very different outcomes for investors, so it's important to understand what those implications could potentially lead to.
Raina Oberoi: Yeah. And I'll just add; from our perspective, given that we are not the product provider, we're usually providing the underlying index, so the strategy is transparency. And the way we bring transparency to the process is all our methodologies are publicly shared. Everyone knows exactly step by step what is going into the construction of this portfolio. And I think MSCI is in a unique position because when we do design these transparent strategies via indexes, we also have our analytics business and our tools that tell you, okay, you just got a value index constructed by MSCI. Now let's put it through a risk model and see what is your value exposure in that? Is it a portfolio that actually is most tilted towards value or is this analytical lens giving you something else where maybe there's another factor that is in there which could actually influence the outcome of the strategy and prevent you from getting that actual exposure to value?
Raina Oberoi: So I think from our perspective, transparency is really important. And also, education to our clients. Our clients for us as something that we start out from the beginning in terms of education, we help them go through different options they have in terms of portfolio construction and the strategies, and then we are there with them till the end in terms of monitoring their exposures and trying to explain to them that, "Okay, well, if you feel your portfolio hasn't been driven by value, let's look at it. Let's understand it, and let's explain to you what really went on here."
Remy Blaire: Raina, Lance, you provided very helpful insights, and I think that analogy to the car and looking under the hood was very helpful. If you don't know what you're doing when you're looking under the hood and by accident you do something wrong, that can be very costly. So that is a very helpful analogy. Now Raina, bringing it back to you, I do want to talk about ESG and incorporating factors along with ESG. So, can you tell me how MSCI is helping investors with the process right now and tell me about some of the benefits of this approach.
Raina Oberoi: Sure. So ESG, as many would have heard, is something that's the buzz word and people again, use it differently, like any form of investing. But MSCI has been a big thought leader and a proponent of ESG based strategies. So, something that's pressing for a lot of our clients are that, "Okay, I am a believer in factor based investing, but I also have some ESG based views." Either it could be just based on governance. I believe that governance is an important criteria I want to incorporate in my factor based strategies or I have some social views. I have some environmental constraints that I want to add in there.
Raina Oberoi: So what is the best way to actually construct a portfolio that can give me all these different attributes? Now, you could start with a simplistic approach with a two-step approach where you're like, "Okay, you know what, I'll start with the broader investible universe. I'll cut it in half, I'll take the best ESG companies, and then I'll start building my factor portfolios based on that." Now, that is one approach. But what that approach does is at the onset, you're leaving 50% of your equity universe out. You're leaving some premium on the table at the onset.
Raina Oberoi: So, for us, that is actually a suboptimal approach. The approach we consider as more optimal is a more integrated approach where you are still building your factor portfolio like you normally would, but you would just tweak it or tilt your stocks more towards certain ESG profiles or certain ESG scores. So, in a sense, you still have your factor portfolio, but today it's a better ESG portfolio than what it was yesterday. So, for us, it's been a big, again, a big journey in terms of educating clients that incorporating ESG in your factory portfolio doesn't necessarily mean you're giving up return. What is the best way of actually keeping your return that you would get from a factor based strategy but still incorporating ESG is what we are trying to solve for, and the integrated approach solves for that.
Darby Nielson: Yeah. We spent a lot of time looking at ESG at Fidelity in particular looking at your data, which is pretty good data. But from a quantitative perspective, I just wanted to take a look at it, like how does it perform over time? What are the different exposures, that kind of thing. And there's still, I think, some debate as to whether or not ESG actually adds alpha and whether it's the E or the S or the G. The answer can vary. But I still think it's important. It's important to think about the exposure. And what we did find, I think, as you said, is that when you intersect these ESG exposures with traditional factor investing, whether it's value, momentum or quality, you can actually get something that can be a little bit better over time, which sounds like what you guys found, which is a pretty compelling result.
Remy Blaire: And I think it's interesting because we've seen evolution in ESG as well as factor investing over the past several decades. Now, we've had quite a good discussion of factor investing, and we've highlighted a lot of the risks that are associated with this type of process. So, are there any myths that you would like to address regarding factor investing and misconceptions that you'd like to clear up?
Lance Humphrey: There's three that I can think of off the top of my head where... I think the first one... and we've touched on this, which is that all factors are good. There's many factors. A factor could be anything. It could be the country that a stock is in, it could be the industry that a stock is in, which are incorporated in many factor models. But that doesn't necessarily have a premium tied to it. So just because a stock is listed in the United States versus listed in Europe, it's a factor, but there's not necessarily a return premium that we would expect between those two. However, there are factors, again, such as value, momentum, quality, size, which we do think have a premium associated with them. So again, I think it's just important that not all factors are created equal, and there are ones that have stood the test of time more strongly than others.
Lance Humphrey: Number two would be... I think that there's really a myth that in order to fully capture these factors, that you have to have a concentrated portfolio. I think there's a lot of debates I hear at conferences and among colleagues where if the portfolio is not super high active share with 50 names, that it all the sudden becomes not real anymore, which is a term that is thrown around. And I think that again, it all comes back down to client objectives. There's many clients who say, "I'd like to have exposure to the value factor, to the momentum factor. However, I also want to be somewhat close to the starting benchmark."
Lance Humphrey: And so there's ways to construct portfolios that do tilt the portfolio in that way while doing it with the benchmark still in mind. And again, there's not a right or wrong answer, but certainly, it does not have to be super concentrated in order to be qualified as real. And then the last one I'd bring up, which is a little bit more specific, but I did talk about volatility rating earlier. And there's often times a myth that volatility weighting a universe is a low volatility strategy. Those are really two different things where the volatility weighting could be, again, a construction put on any type of portfolio.
Lance Humphrey: It could be on high volatility stocks or on quality stocks as opposed to a low volatility or a minimum volatility type of portfolio is specifically targeting to be lower volatility than the markets. I know that could be confusing, but I just wanted to say that again, the volatility weighting is not necessarily a low- ball strategy, but instead it seeks to enhance the diversification within the portfolio.
Raina Oberoi: Yeah, and I would add, something that just comes up, and I alluded to it initially when I was talking about just factor investing is that some people think it's a fad and some people think it's a bubble, and it came and it'll go away, and you'll get burned by it. And so, there are a lot of different myths out there, but I think that leads to the question that, what is it that investors should be doing and thinking about when they have such doubts in mind? And I think, again, I talked about the transparency aspect, which is crucial. With that comes the use of actual tools to be able to evaluate your portfolios. What does your portfolio actually contain? And having robust tools helps you do that.
Raina Oberoi: And the last thing I would mention, which is really important is establishing standards. So today when I say value or quality, do you mean the same thing? Are we talking the same language? And that doesn't mean all strategies have to be the same. We should just be measuring them in a more uniform way. And so MSCI has looked at establishing standards as we've tried to do in other areas in this area too by launching something called MSCI facts, which is a simple box which tells you these are the different exposures, this is the standard exposures of the standard Lens. You should be putting your factor portfolios too, so that when you are comparing it to someone else's portfolio or when you are trying to do some reporting, everyone knows exactly what your portfolio consists of, you know what your portfolio consists of.
Raina Oberoi: So yes, I think all these three things are really important for investors to become comfortable because at the end of the day, it is the investor's belief in factor investing. We cannot convince anyone that they should be investing in factors unless they themselves believe it.
Darby Nielson: Yeah, I would just say that I like what Lance said about this belief, that all factors can potentially add excess return, which is just not true. There's a lot of factors that don't. That's what I meant before when I tried to split hairs and said maybe smart beta are the ones that outperform, but the rest of factor investing is not, even though to me the phrases are interchangeable. But even beyond that, I think that the smart beta or the ones value momentum quality that have added value over time, I worry there might be a belief out there that they work all the time.
Darby Nielson: You can buy a momentum product or particularly a value product of the last several years and you can have one to three years of underperformance. It may be a myth out there that if you buy one of these alpha generating over time factor products, you'll get it all the time, which just is not true. And then the last thing we've talked about, but I want to highlight because it's important is any sort of myth that all factor products are the same. They're not a commodity. You can look at a bunch of value, a bunch of quality momentum, whatever. Depending on the factor selection or the portfolio construction decisions, you can get very different returns. So that is a myth that I think might be out there, that they're all the same.
Remy Blaire: And I think it's very helpful to clear up some of these misconceptions as well as myths surrounding factor investing. There are a lot of financial professionals as well as advisors watching this master class. So, do you have any advice for these advisors and how they should approach factor investing when they're talking to their clients?
Lance Humphrey: Sure. Well, to summarize some of the thoughts that we've had today, I would say, when we work across many client advisor portfolios, what we find is again, portfolios that maybe contain three or four active value funds and three or four active growth funds. And I think it was Darby that mentioned it earlier where... And we have the tools now that we can go in and look to say, are we really getting active exposure or differentiated exposure from this conglomerate of active managers? Or in fact, could we replicate some of these exposures by using factors? So again, I'm bringing that up because it's something that we've done within our own portfolios at USAA.
Lance Humphrey: We've gone and said, can we target these factor exposures but do it in a much more transparent, in a lower cost way than with the portfolio of active managers? We still believe in active managers, we use them across our portfolios in many different contexts. So, I would say the main thing that an advisor could take away is to look at the overall portfolio and ask the question, could I increase the efficiency of what I'm trying to accomplish by mixing together traditional active passive along with factor based products?
Raina Oberoi: When we talk to our wealth segment, we see that there is some sort of a bifurcation in knowledge. Some of them obviously understand the factor investing story, they believe in it, they are trying to incorporate it while others have not kind of jumped on the wagon, as they say, yet. But I think the home offices are actually producing some very, very good research on how to incorporate factors in the investment process. We at MSCI also have a very, very focused initiative on educating the wealth segment on factor based investing.
Raina Oberoi: So I think the education has to happen at the advisor level for them to believe in it, because they have to believe in it, they have to see it. Some of the onus is on us as a firm as well to put out research that would actually convince the advisors that there is value add in incorporating factors in your portfolio and this is what you miss out on, this is what you leave on the table by not even considering it. So, I think that is something that I would suggest and advise, is that be open to understanding what factor investing is. And we're not seeing it as for everyone, but at least explore it.
Darby Nielson: Yeah. I would just say maybe tying it all together here. The first thing I would suggest is just learn about factors. What are they? What is a factor? And then from there, what are the different kinds of factors, and how can they be used in different ways? Maybe low vol for risk reduction and maybe momentum and quality for adding alpha over time, potentially. So, learn about factors, learn the different ways to use them. And then as we've been saying, learn about how to evaluate them. Because they're not all the same, it's important to do the due diligence and understand what the differences are.
Darby Nielson: And then I think once you go through that process, from there, look at your portfolio and figure out, what factor exposures do I have? And then from there, once you understand how they work, once you understand what exposures are in the portfolio, then you can figure out what you might want to do. Maybe you don't want to do anything with them. There are plenty of active portfolio managers who may not use factor models in their investment process explicitly, but it's helpful to know what your exposures are and then figure out if you want to do something from there. And we do that all day long with active portfolio managers. So that's what I would suggest. I think I may have tied things together here, but I think if I was an advisor, I would think about it in that way.
Remy Blaire: And last but not least, before we wrap it up for today's masterclass, as we head into the second half of this year, we know that people are looking at trends and what we might see in the economy. We've been talking about the evolution in factor investing, but are there any trends or anything in the industry you expect to see in the short term or the mid-term?
Raina Oberoi: Yeah, sure. So MSCI actually, has a quite packed research agenda, and the research agenda is packed is because we have... seeing these trends in the industry that we feel that we can actually play an important role in. So, we spoke about factors, obviously, here we were discussing mainly factors in the equity space. Something that we are exploring and we've already done a lot of work around is multi asset class factors. How do you think about that? How can you capture fixed income factors in a rules based and transparent fashion?
Raina Oberoi: So around, that I feel there is a lot more interest not only in equities, but also beyond equities on how can you capture the systematic sources of return that are out there in a rules based transparent fashion, and then also, of course, in a cost-effective way?
Darby Nielson: Yeah, you stole one of my-
Raina Oberoi: Sorry.
Darby Nielson: ... trends. Not, it's okay. But I agree with you. I think that it's still early days for factor investing in fixed income. It's been a while in equities, I think, and there's quite a few products out there. But I think you're going to see a lot more research in the fixed income space going forward. I also think you're going to see more excitement or perhaps research around... we talked about ESG. It seems like the industry is continuing to move in that direction, which to me, it's measuring an exposure. So, in a way, ESG or just different types of factors.
Darby Nielson: We've been talking about how factors are really just exposures to certain things, and so I think you're going to continue to see interest in ESG. And then lastly, I mentioned this in passing earlier, but I think exploring ways to use AI or more alternative algorithms to identify new factors at Fidelity. We're exploring AI in a lot of different ways across the firm to see how it can enhance what we do at Fidelity to augment our investment process maybe just to make the investment process more efficient. But I think there may be ways to explore these algorithms to come up with new factors and come up with new ways to create portfolios.
Remy Blaire: Well, I think we've covered a lot of ground, so thank you so much for joining me for today's masterclass.
Lance Humphrey: Great to be here.
Darby Nielson: Thank you.
Remy Blaire: And thank you for watching. I was joined by Darby Nielsen, managing director of research equity and high income at Fidelity investments, Lance Humphrey, executive director of global multi assets and portfolio manager at USAA Asset Management Company and Raina Oberoi, executive director, head of equity solutions Research for Americas at MSCI. From our studio in new city, I'm Remy Blaire for Asset TV.
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