Investment

Portfolio managers beware: factor based ETFs and how they can be helpful

by Martin Frenette

Breaking down your broad universe of food groups into their more basic elements and nutrients is now part of our daily habits. Checking labels for sugar, fat, carbs and protein content isn’t just the remit of Californian health freaks but something that is part of every shopper’s habit nowadays. Although worlds apart from a chef preparing a meal in a restaurant, most asset managers will look at factors in exactly the same way we look at key ingredients: factors are to assets what nutrients are to food – both cream and pork bellies contain protein and fat, just as economic risk is present in public equities, private equity, high yield and hedge funds. Understanding portfolio drivers or risk and return through factor analysis isn’t much different from understanding how food groups react with each other under hot and cold conditions to produce the perfect meal. Following the path of the food industry, the disaggregation of investment returns which began with the CAPM in the 60s and advanced by the Fama-French three factor analysis in the 90’s has now moved from theory to the real world.

Many active managers have therefore used factor based models quite extensively with the building blocks of their factor analysis revolving mainly (for equity managers anyway) around value, small caps, low volatility, high yield, quality and momentum. A few years back when I worked for a large Swiss group, risk management would sit down with PMs and look at their portfolio based on the factors above as well as sensitivity to rates, oil and other more macro elements. If the PM claimed his or her main source of return was based on fundamental work and stock picking, the factor chart would have to reflect that, essentially showing very little exposure to any given one. If the factor study showed strong correlation to one or two factors, then performance (and risk) was driven by something outside their remit and we were confronted with a binary choice: either accept we’re paying fees for something that was a static bet (more often than not coming from the PMs style) or simply redeem. There was very little else we could do.

‘Today there’s a wide range of factors through smart beta ETFs that are available to investors which give a new range of options’ states Angel Sanz, Notz Stucki’s Chief Economist who analyses manager talent (or lack thereof) on a daily basis for the firm. ‘When a team comes by our office to see us, first thing I’ll do is look at regressing their performance on my Bloomberg terminal against several factors and try to understand what types of exposure they’re offering on a factorial basis. If they’re unaware of how their return stream looks through a factor model or can’t address the differences between their portfolio’s characteristics and those of the closest factor index, it will make for a very short meeting. In the past, I may still have invested’ opines Sanz ‘if I felt this type of factor exposure made sense (i.e. I was underexposed to this factor) even though I felt fees were egregious for something that didn’t require much talent. Today though, why would we want to pay fees to an active manager when ETFs are readily available that can give me the same kind of exposure?’

Graph 1 performance of actively managed German equities Fund vs its index
Graph 1 performance of actively managed German equities Fund vs its index

Graph 1 above looks compelling right? At first glance, this manager investing in German equities (black line) looks like they’re adding quite a bit of value (or alpha) vs the DAX (yellow line).

smart beta
Table 2 linear regression of the fund vs German equity risk premia

But a closer look at a regression analysis on Bloomberg, trying to explain his or her returns shows a different picture. In table 2, it becomes clear that almost 100% of the performance can be explained by 2 factors, the DAX and the MDAX (the German mid cap index). The constant or alpha is low and not even statistically significant (i.e. t-test below 2)… a different proposition altogether.

To get back to basics, an active manager’s return in excess of the benchmark can be broken down into three components (1) returns to static factor premia, such as tilt to value or momentum stocks (2) manager skill coming from factor timing and (3) manager skill coming from security selection. Points 2 and 3 are the only things we’re willing to pay for and now we can do something about it.

It can also help assessing what kind of risks we have in our overall portfolio. Factor based studies also help us better understand, on a look through basis, what kind of risks we’re taking for our overall portfolio. Norges, the (very) large Norwegian wealth fund and government pension plan, were instrumental in addressing this. In late ’08, they were surprised at how their investments, which had supposed independent bets and offered adequate levels of diversification, all collapsed in tandem. It was their drive in trying to understand what they had exposed themselves to that led to this development, ultimately pushing most institutions to look at factors in a more granular way.

‘I’m looking to pay active managers who generate genuine alpha through either tactical timing around markets and factors or through security selection. Static factor tilts can be replicated more cost efficiently with smart beta strategies’ opines Sanz and goes on to conclude ‘the availability of smart beta ETFs helps me improve portfolio outcomes, reduce costs and more importantly increase performance transparency’.

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Antonio Mira
CHIEF FINANCIAL OFFICER, MEMBER OF THE EXECUTIVE COMMITTEE

Antonio Mira joined NS Partners in 2006 as Group Chief Financial Officer. He heads the corporate functions and is involved in coordinating and implementing the decisions of the Executive Committee.
An experienced bank auditor, Antonio started his career in 1995 with Arthur Andersen, where he worked for some 7 years before joining Ernst & Young in 2002 as a Senior Manager.
Antonio is a Swiss chartered accountant and a Business graduate of Lausanne University (HEC).

Sébastien Poiret
DEPUTY HEAD OF WEALTH MANAGEMENT

Sébastien Poiret joined NS Partners in 2008 and manages funds of hedge funds and private client mandates. He also oversees the development of the Group’s offices in Mauritius.

Prior to joining NS Partners, he served as a Trader, Head of Manager research and Portfolio Manager in the USA and Switzerland for a single hedge fund (1998-2004) and for Optimal (2004-2008), Grupo Santander’s fund-of-hedge funds operations.

Sébastien holds a Bachelor’s degree in Corporate Finance from the ESPEME Business School (EDHEC Group) and an MBA in Finance and Economics from the Institute of Business Administration, both in Nice.

Abir Oreibi
BOARD DIRECTOR

Abir Oreibi joined the Board of the NS Partners Group in 2018, where she brings her truly international perspective and rich experience.
Among many other ventures, Abir set up Alibaba.com’s first European office. After living and working in Shanghai, Hong Kong, Bangkok and London, she now lives in Geneva, where she is CEO of Lift Events, an organization that identifies technology trends, their business and social impact through the organization of events and open innovation programs. Issues related to the challenges and opportunities created by new technologies as well as the strategic responses from organizations are at the heart of Lift’s activities.
Abir holds a BA in Political Sciences from the University of Geneva. She is an investor, and member of advisory and innovation boards.

Romain Pidoux, CAIA

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Romain Pidoux joined NS Partners in 2011 and heads the Group’s Risk Management.
He started his financial career in 2005 as Head of Quantitative Analysis for a Swiss Family Office, selecting funds and managing portfolio allocation. In 2008, he switched to the alternative world and joined Peak Partners as hedge funds analyst.
He is a Chartered Alternative Investment Analyst (CAIA) and holds a Master’s degree in international relations from the Graduate Institute of International Studies at Geneva University.

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