ANDREW'S ANGLE

Factors + Alpha + Index

Jul 5, 2018

ANDREW'S ANGLE

Yesterday’s alpha has been unbundled into market capitalization index, factors and alpha-seeking investments. What does this mean for investors?

The first album I bought was Thriller by Michael Jackson. I loved hearing and seeing this phenomenal artist. But even on this blockbuster album, I tended to listen to my favorite tracks: Billie Jean, Beat It, and Thriller itself.

Released in 1982, Thriller sold 66 million copies, and album sales have been shrinking since. Music streaming services like Spotify or SoundCloud mean we no longer need to buy the whole album. We listen to the tracks we want, at the time we want—and our playlists are better for it.

Just like the music industry, asset management is undergoing a transformation of its own.

Separating the Tracks

Separating the Tracks

Source: BlackRock, August 2018. For illustrative purposes only.

In the 1980s, when I was buying Thriller, investors used to go to one investment manager and buy all the tracks. The investment manager would bundle market-capitalization weighted index (or beta), factors, and alpha together. Beginning in the 1990s, we started to measure the returns generated by active managers in excess of market cap benchmarks. Today, we recognize that some of those excess returns are now attributable to factors—broad and persistent sources of return that are well understood but have continued to endure. True alpha today involves specialized skills, or being able to react tactically to non-repeatable market conditions beyond factors.

Just as you no longer have to buy the whole album, investors can now take the components that are right for them and pay the commensurate price.

Amplifying the Sound

Just as three chords (I-IV-V) underpin much of Western music, here a couple of principles to ensure the different portfolio components—index, factors, and alpha— play in sync:

  1. Select appropriate managers.Once you understand what’s really driving the returns of different funds, manager selection can get a whole lot easier. If you want one simple rule, try this: don’t pay active fees for factor-based returns.
  2. Consider revamping your portfolio. Chances are, you may want to make some changes to your existing portfolio. In addition to replacing active managers that aren’t delivering true alpha, you may want to add certain style factors in an effort to obtain more balance in your portfolio. Some investors may consider tilting toward certain factors, depending on where we are in the business cycle.

Finding the Right Mix

When you’ve completed the preceding exercise, you may decide that, like many investors, you want a mix of index, alpha-seeking, and factor strategies. The process of combining these is a lot like making a playlist, or as they called it in my day, a mixtape. And just as different music genres play different roles on a great mixtape, different investment strategies bring something unique to a well-constructed portfolio.

  • Highly fee-sensitive investors should consider tilting portfolios towards low-cost factor and index strategies.
  • Factor believers can hold index investments to provide exposure to a market-cap benchmark and factor investments to seek incremental returns above an index.
  • Investors able to take large active deviations from a market cap benchmark may want to consider a barbell strategy, with index and alpha-seeking managers.
  • Investors seeking all sources of diversified returns can consider a balance of index, factor, and alpha investments.

No matter where investors fall on the spectrum, it’s possible to design a highly personalized solution to help achieve specific objectives. Now that, is music to my ears.

A balance of index, factor, and alpha investments

Source: BlackRock, August 2018. For illustrative purposes only.

Andrew Ang, Phd
Head of Blackrock's Factor-Based Strategies Group
Andrew Ang, PhD, Managing Director, coordinates BlackRock's efforts in factor investing. He leads the BlackRock's Factor-Based Strategies Group.