A common ‘smart beta’ portfolio construction technique could be fudging factor exposures, a new FTSE Russell paper argues.
The FTSE Russell analysis found the popular ‘selection and weighting’ (SW) smart beta portfolio construction method can lead to factor pollution as well as diversification and implementation weaknesses.
Under the SW technique managers build portfolios by selecting the highest-ranked stocks based on ‘factor’ scores – such as size, quality and low volatility. The study compares a number of SW portfolios – targeting a range of factors and using different weighting rules – against similarly-themed portfolios built on the FTSE Russell ‘multiple tilting’ technique.
While both portfolios performed roughly the same across all factors included over the 18 years ending September this year, the paper found the multi-tilt approach resulted in greater diversification and fewer implementation issues (as measured by ‘active share’, for example).
“Portfolio construction therefore matters when one turns to the practical considerations of meeting stated objectives, replication, robustness and cost,” the study says.
SW portfolios also tend to skew away from ‘pure’ factor exposures, which could lead to performance surprises.
“Selection and Weighting introduces multiple, uncontrolled off-target factor exposures through the choice of a particular weighting scheme,” the paper says. “In a single factor context this would be misleading and potentially dangerous, since the performance attributable to such an index arises from multiple factor sources, with the target factor playing possibly only a minor role.”
For example, the analysis found a SW-built ‘quality’ factor portfolio would not have performed as expected during the peak global financial crisis period over September to October 2008.
While exposure to pure quality stocks over that month would’ve seen investors outperform by almost 2 per cent, the SW portfolio targeting that factor would’ve underperformed the benchmark by a similar amount due to exposure to other factors (notably, ‘size’).
“This is an example of where factor purity is important in obtaining the outcome sought and expected,” the report says.
While both SW and multi-tilt factor portfolios outperformed the broader indices, FTSE Russell says the findings highlight “the dangers of simplistic performance comparisons that do not relate performance directly to stated factor objectives”.
But overall the “performance outcomes pretty much confirm what the academics have told us – factor exposures matter”, the paper says.
Factor investing, or smart beta, is becoming increasing popular with institutions – including the NZ Superannuation Fund – while many financial advisers favour the approach by investing in funds offered by Dimensional Fund Advisors (DFA), for example.
DFA pioneered factor-investing via the famous Fama-French model, named after Eugene Fama and Kenneth French.