Since the 1960s, financial theorists have been building models that explain stock returns as a function of their risk exposure. Originally, the capital-asset pricing model focused on a single factor – market exposure – as the driver of returns. By the 1970s, however, financial theorists were proposing an array of factors – fundamental, macroeconomic and statistical – as the determinants of expected returns.
However, two papers published by University of Chicago professors Eugene Fama and Ken French in the early 1990s established two other factors – firm size and the book/market equity ratio (i.e., value) – in addition to an overall market factor as the variables that explain stock returns.
The outperformance of small-cap and value stocks over long periods of time, phenomena that had long been identified by many finance theorists, now had a firm academic foundation.
Since then, additional factors have been identified to explain stock market returns. Long-term outperformance has been linked to groups of stocks that offer positive momentum, low beta, robust profitability and conservative rates of investment. Not surprising, index providers and exchange-traded fund (ETF) portfolio managers have collaborated to produce an ever-growing array of ETFs designed to capitalize on these factors.
However, certain active mutual fund portfolio managers appear to have not ignored the opportunity to pursue market-beating returns through factor exposures. In a white paper recently published by Robeco Institutional Asset Management BV, that firm summarized its research on factor investing based on a large sample of U.S. equity mutual funds over the period from 1990 to 2010.
Robeco’s study found that, depending upon definition, 20%-30% of funds engage in either small-cap or value investment strategies. A much smaller number (2%-6%) use momentum or low-beta strategies.
Funds that have adopted small-cap and value strategies earned benchmark-beating returns. Small-cap and value funds earned average alphas of 0.56% and 1.19% per year, respectively, net of all costs when compared with the market index. Low-beta funds earned market-like returns, but realized significantly less volatility. The results were mixed for funds engaging in momentum strategies: although the majority outperformed the market, exceedingly poor results by some suggest that momentum is a more difficult strategy to execute.
Conspicuously, 80% of the funds that did not adopt a factor strategy had negative alphas, with the largest number earning minus 2%-3% a year. Of the 20% of no-factor strategy funds that outperformed, half had alphas of 0%-1%. In contrast, 47%, 61% and 66% of funds that engaged in low-beta, small-cap or value strategies, respectively, had positive alphas – with the majority of these in excess of 2% per year.
Funds that were exposed to more than one factor strategy were even more successful. Sixty-eight per cent of funds engaged in two factor strategies outperformed the market with an average alpha of 1.45% a year, while 78% of those adopting three strategies beat the market with an average alpha of 1.64%.
Clearly, active portfolio managers can use factor investing to enhance returns. In Canada, the key is offering such strategies at a cost that allows the investor, and not the portfolio manager, to earn the excess return.
Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm. The company, its principals, employees and clients may own the securities mentioned herein.
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