SPOTIFY, FACTOR ETFS AND THE EVOLUTION OF INVESTMENT

I went to high school in Perth during the 1980s and I really loved buying music. The first LP I bought was Kylie Minogue’s album ‘Kylie’. As much as I liked Kylie Minogue, I preferred ‘I Should Be So Lucky’ and I didn’t really like ‘The Locomotion’ that much - but in those days you had to buy the whole album.

What’s happening today with finance is exactly the same as music – today you don’t have to buy the whole thing. With streaming services like Apple Music and Spotify, you can listen to precisely the songs and tracks that you want, in the format that you want, when you want. In asset management, we used to have to buy the whole album - one manager that gave us a collection of index or market exposures. We also had that asset manager give us tilts towards style factors like value, quality, momentum, low size or low volatility. That alpha manager also gave us returns in excess of those style factors and market exposures - but you had to buy the whole album to get them. Today, you can buy the parts you want, that are appropriate for your clients, in a format that is suitable for your business.

Factors like value, quality and momentum are not new. They were first referenced by Columbia accounting professors Graham and Dodd in their book Securities Analysis in 1934, which became a bible for the investment management industry. They advocated using a systematic approach through analysis of financial statements, balance sheets and earnings statements to come up with a stock valuation – effectively the big data of the 1930s.

What is new is the ability to put these factors into different formats, to harvest these in different ways – to put the power of buying cheap, or buying into trends, or buying quality stocks, into ETFs, tailored portfolios or managed accounts. What is new is the ways we can access these long-term drivers of return.

How can we use these factors? They’re highly complementary to index and active strategies.

There’s actually nothing wrong with market exposure, or being average. I wish I were average, but unfortunately I’m only 163 centimetres tall on a good day. But sometimes being average is not good enough – you might want to seek higher expected returns or greater robustness and resilience in your portfolio. Factors can really help with that.

We can also use factor strategies as a complement to active strategies. Sometimes you may build an active portfolio that doesn’t have all the factors, so we can add factors that are diversified. In some cases, we might be able to replace expensive, underperforming active managers.

I recently published a paper in the Journal of Portfolio Management with colleagues from our portfolio consulting teams, where we looked at 800 model portfolios in the US. We looked at moderate 60-40 portfolios, both strategic and tactical, and we calculated the various risk characteristics of these model portfolios.

What you can see in the charts below is there’s only one factor exposure that really stands out in these portfolios, and that’s small size. The other factor exposures are neutered and some of them go the wrong way – I think we would want high quality firms rather than low quality, and we would probably want to find positive price trends rather than no trends at all. The first thing we can do in this example is add factors we don’t have.

The next example uses Aussie portfolios. The first portfolio is using active funds, the second one uses ETFs and the third one uses single securities. Let’s focus on the first two.

Factor exposure of example Australian portfolios

One of the interesting things to note is that while US investors have a pronounced small cap tilt, Aussie investors have a pronounced large cap tilt. What we can do is add single factor ETFs to round out these portfolios. For the portfolio that uses active funds, you can see there’s a big rise in the value exposures for this portfolio, and a bit of an extra increase in quality. For the second set of portfolios using ETFs, we add quality and momentum for an increase in momentum exposure, as you see in the first column.

Implementing factors in our example portfolios

When we look at the individual security portfolio, we should actually get the best bang for our buck here.  Factor ETFs help us with more efficient exposures, particularly for those static factors. And if an active manager is only providing static factor exposures, there’s actually a more efficient, transparent and low-cost way of getting that – through single factor and multi-factor ETFs.

It’s easy to use single factor ETFs to round out your portfolio. You can think of it as the playlist of finance – we take each of these different components and serve them up in the way you want, when you want. If we take static factor exposures in single factor or multi-factor ETFs, that leaves us firepower to concentrate our risk-taking where it’s most efficient – this is where high performing active managers may come to the fore.

One question you might have is if we’ve known about factors since the 1930s with Graham and Dodd, why have these factors persisted? Why are they relevant today and will they be there in the next 100 years? All of these factors are based on economic rationales. There are tens of thousands of academic papers documenting factor premiums. There are six Nobel prizes awarded in the area of factor investing. This gives us confidence that while we’ve observed them for decades, if these economic rationales persist as I think they will, they will be around for the next century as well.

A 2020 study published in one of the top financial journals, the Review of Financial Studies, looked at 30,000 stocks across 60 years of data and 94 different characteristics. They used machine learning to extract out all the performance commonalities, and they found that they were:

• Recent price trends, or momentum;
• Liquidity variables, like small size;
• Risk measures, such as volatility;
• More traditional value and fundamental (quality) signals

These factors are exactly the same as those discovered by Graham and Dodd in the 1930s, so in one sense nothing has changed. What has changed is the way we access these long-term, intuitive drivers of return.

Adapted from Andrew Ang's presentation at the 2024 Wealth Symposium.