Factor-based investing is cyclical and can be tailored to the current market landscape – but don’t think this makes asset allocation any easier.
That’s the view of Vishal Bhatia, director, portfolio manager, ETFs, BMO Global Asset Management, who said advisors can help clients by taking a big picture approach to portfolio construction.
Bhatia believes the main factors – value, momentum, growth, for example – will outperform over the long run (8-10 years), more or less depending on the stage of the cycle. Transferring this to an effective client portfolio is the challenge for advisors. So how can they successfully incorporate these factors?
Speaking at the Radius 2019 Exchange Traded Forum in Toronto, Bhatia said: “One of the ways is to take a big picture view of an overall portfolio and access the factors that they already have. So maybe their manager has a persistent tilt to value and they would like to complement that to another exposure that’s perhaps negatively correlated for a smoother ride. That’s one way to complement the portfolio construction process.
“Another way would be to look at your active manager. Perhaps they have delivered a lot of value through persistent style tilts; small cap tilts, value tilts, for example.
“Once you realise, through the miracle of the ETF wrapper, that you can transparently and cost-effectively obtain pure factor exposure efficiently, it becomes really compelling to perhaps consider replacing insurance strategies with ETFs that allow you to gain so much more of that thematic exposure in a more positive way.”
At the current stage of the cycle, Bhatia said quality and low volatility factors are the most effective tools to combat market conditions, although he reiterated that all factors have been proven – over 50 years of academic research - to deliver over a long investment horizon.
He said: “We are at the stage of the cycle in which, by most accounts, we are late innings of a record long bull market. We tend to favour quality or low volatility for maximum defence but still ensuring participation in the equity market. [Go for] quality if you are looking for some insulation effect as well as investing in companies that have an economic moat and strong returns.”
He added that low volatility’s outperformance over the long term is counter-intuitive in many ways but can, in part, be explained by investor behaviour. “Investors on aggregate tend to prefer bright, shiny stocks. The inner magpie in them prefers sexy stocks and higher risk to try to knock it out of the park. Collectively, therefore, they neglect the stocks that are quietly churning out the profit.”
Jeff Weniger, director, asset allocation, Wisdom Tree Asset Management, made clear his dislike for core satellite approaches and preferred to point at the half a century of studies as to why the factors should be the baseline for 100% of all portfolios. He said: “Why should I settle for something that I know is not going to outperform.”
However, he warned that there are some aspects specific to the "Canadian conversation" as opposed to the US situation.
“You have sector concentration in this nation, so make sure you look under the hood of what those exposures are giving you. For example, our flagship fund we have here, our Canadian equity, has none of the big five banks in it. We screen for returns on equity and they aren’t showing up very high on that metric – it’s picking up the insurers. [Our fund] will either be to your liking or you will be laughed out the room!”
He added that the other reason for looking under the hood was potential bias to provinces, specifically Alberta and energy and urged advisors to make sure that's what the client wants. He also highlighted why investors should be considering the often-forgotten factor of CAD.
He said: “It’s the other side of the G7 spectrum where it’s CAD over here and the Yen over here, this risk-on, risk-off paradigm, so you want to tie that in.
“That’s a bigger conversation here because Canadian equity exposure in the context of a local portfolio is so much smaller than the conversation you are having with an American where one out of two dollars in the global pecking order is in US large cap.”
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