Alpha isn’t easy to create. For every
successful investor who beats the market,
there must be another investor who loses.
Many financial economists have spent
their careers digging for fund characteristics, or factors, that consistently add
a higher rate of return than beta alone.
Access to data and advances in statistical techniques have helped scientists
build a list of reliable factors that could
be exploited by asset managers smart
enough to pick up the easy alpha that
Every year, I have my graduate students estimate alpha from historical
fund data using a range of characteristics, such as recent performance,
fund family and manager tenure. The
only consistent predictors are always
expenses, beta, value and size orientation.
Value investors have harvested alpha so consistently that
financial economists consider it the gold standard of all
investment factors. Much of the success of star investors like
Peter Lynch and Warren Buffet can be attributed to their
attraction to small, cheap companies. An investment in value
stocks has simply been a license to take wealth away from ill-informed, emotional growth investors who consistently leave
money on the table.
It turns out investing itself isn’t quite that easy. Growth
investors have eaten value investors’ lunch over the last
decade, happily wiping away their smug research-based grins.
Even though the gold-standard factor has lagged, industry experts such as Larry Swedroe of Buckingham Strategic
Wealth and Cliff Asness of AQR Capital Management point
out that factors don’t tend to be highly correlated and, when
combined, can consistently produce alpha without bearing the
risk that a single factor won’t be productive. Combining factors
can be the smart way to capture the elusive alpha.
Smart-beta investors can take advantage of the tax benefits,
low costs and liquidity of the ETF structure through a new
breed of multifactor investments that hunts for alpha using a
variety of research-based strategies.
The Multifactor ETF
A new generation of ETFs promises to intelligently combine
research-based factors through a low-cost platform to generate better outcomes than plain-vanilla beta ETFs. This means
paying attention to the research to better understand what
factors are consistently generating higher returns and combining them to give investors the best shot at outperforming
According to John Feyerer, senior director of Equity
ETF Strategies at Invesco, multifactor ETFs “democratize
access to what institutional investors may have utilized for
decades. What’s game changing for investors and financial
advisors is their ability to incorporate these factors into
What factors can produce alpha? Since researchers are
constantly testing new and old factors, our understanding of
which factors are most reliable and how to productively com-
bine factors improves and changes over time. “We believe
that there are five or six factors that make sense — value,
size, momentum, low volatility, quality and dividend yield,”
“When you look at the criteria for a factor to be considered historically rewarded, one of the things you need to
see is excess return in the full history and out of sample,”
“If it was discovered years ago, does it continue to persist
out of sample domestically and globally? Does it have a logical reason to exist? Is there an economic rationale for why it
existed and why it should persist? Are the returns statistically
significant?” he asks.
The longstanding criticism of factors is that they arise
from data mining by researchers who hope to find correlations between investment characteristics and returns in the
historical data. In a recent interview, Bill Sharpe discussed the
possibility that many of these factors are the result of random
trends and prone to disappear or even revert to a negative
alpha once identified.
Ben Johnson, director of Global ETF Research at
Morningstar, agrees that factors need to have a reason
to exist before advisors can be convinced that they will
“[A factor] has to be
something that is backed by
intuition. Value is incredibly
intuitive — it makes sense.
Buy things that are priced
at less than what they’re
worth. They have to be
vetted by academics and
practitioners. If there are
two that have passed the
test, I’d argue that they are
value and momentum.”
—Ben Johnson, director of Global
ETF Research at Morningstar