By Jason Hsu
Every year we invite some of the investment industry’s most creative thinkers to speak about their work at the Research Affiliates’ Advisory Panel conference. This year much of the discussion centred on aspects of factor investing.
Andrew Ang, a renowned theoretician, author and practitioner, presented a framework for factor investing that encourages investors to think more about factors and less about asset classes (Ang, 2014). In his research, Andrew argues that factors are like nutrients as asset classes are like meals. Ultimately, what we care about are the vitamins, amino acids, proteins, carbohydrates, and other nutrients we get from meals.
The beauty of this analogy is that it illustrates wonderfully both the power of the factor framework for helping investors invest better and the danger associated with a narrow focus on factor investing while ignoring asset classes. The factor framework tells us that whether we invest in US, European, Japanese, or Chinese equities, we are exposed to the global growth factor and earn a risk premium associated with that exposure. This is similar to recognizing that whether we eat a steak, a duck breast, or a salmon fillet—seemingly very different meals—we are nonetheless eating protein, with little other nutrients like fibre, vitamin C, or complex carbohydrates. This intuition helps us understand more scientifically our portfolio diversification.
However, there is a deeper intuition that is unfortunately missed by most proponents of factor investing. It is dangerous to assume that factor loadings are the only salient information in investing; I think it is a mistake to assume that portfolios with similar factor exposures are largely identical, irrespective of the prices charged. There are numerous combinations of different assets which result in similar factor exposures, just as there is a large variety of foods which can be combined to create different meals providing similar nutrients. While my mother cares deeply about the nutrients in the meals she prepares, she cares just as much about the cost of the ingredients that go into her dishes. If salmon is on sale at the supermarket, Mom will prepare a meal based on salmon.
We need to remember that investors transact in the asset space and that there are often a dozen different asset mixes which provide exposure to the same factor. The successful investor will be the one who buys her factor exposures cheaply. For example, we can buy global growth by buying emerging market stocks or US stocks. Currently, emerging market stocks have a cyclically adjusted P/E (CAPE) of about 12, and US stocks, about 25. Does it not matter whether we purchase global growth through EM equities or U.S. equities?
I also wish to offer caution on the emerging trend toward “pure” factor portfolios. Going back to the food/nutrient analogy: would one consider it wise to replace traditional home-cooked meals with a chemical cocktail of vitamins and nutritional supplements? Similarly, would factor portfolios constructed from long–short portfolios based on complex quantitative models provide more effective and complete access to the essential drivers of long-term returns than asset classes? I fear the definitiveness of some of the factor gurus—a certainty that can feel like hubris. Here, I suspect that we overestimate the current state of knowledge regarding both health and economics.
Jason Hsu is co-founder and vice chairman of Research Affiliates
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