Hoshang Daroga, quantitative investment manager at Copia Capital Management, speaks to ETF Stream’s editor Tom Eckett about the rise of thematic ETFs, best practices for selecting factor ETFs and why his allocation to smart beta would increase if there were long-short strategies launched.

Daroga joined Copia Capital in 2015 from LSV Asset Management, where he was a quantitative research analyst for under a year. Prior to this, he was an equity research analyst at MLV and a senior trader at TransMarket Group.

Do you use smart beta or factor products within your clients’ portfolios?

We use factor-based ETFs and their use very much depends on the investment mandate. We have primarily used these products to increase diversification and away from passive (market cap index tracking) funds or adjust overall risk exposure for a specific asset class.

How much of your portfolios does smart beta typically make up?

The proportion of factor ETFs has historically varied between 0% and 10% and depends on the investment objective of the portfolio as well as market conditions. We have been comfortable with the current level of use as well as selection and are not looking to increase or decrease these exposures.

How do you view smart beta/factor-based ETFs?

We view these products as tools to diversify away from passive (market cap index tracking) investments but also a rules-based active investment. Being rules-based gives it the predictability, making it ideal tools to express specific views and gain targeted exposures in a cost-efficient manner.

Which parts of the smart beta/factor-based spectrum (including thematic ETFs) interest you most at the moment?

For wealth preservation, mandates we really like having a strategic exposure to minimum volatility factor. It has consistently shown to have better risk characteristics compared to benchmark indices.

My personal favourite for alpha generation has always been momentum. It may have some skewed downside over short time periods but over the long term I believe momentum will eventually outperform as it is a behavioural anomaly.

When you focus on a particular smart beta product to invest in what factors do you take into account?

Once we have identified a factor that we would like exposure to, we follow our systematic screening process of identifying all ETFs that could provide the required exposure. The screening system looks for a number of parameters, such as assets under management, total expense ratio (TER), bid/ask spreads, domicile, replication methodology – we prefer physical replication, for example.

Alongside smart beta and factor based investing, we have also seen the rise of thematic ETFs – does this interest you?

Thematic investing has gathered much more interest in the last few years over factor-based strategies. This is mainly due to the strong performance of thematic strategies compared to factor-based products as well as the fact that thematic investing is much easier to comprehend.

We have been using thematics like cybersecurity, healthcare innovation and clean energy in specific portfolios which have all delivered excellent returns over the last year. Although the long term outlook remains strong, we find valuations extremely stretched and may lighten up on some of them.

Are you concerned by the recurring accusations of hacking and data mining levelled at all factors and smart beta strategies? Are the identified premiums really that robust?

Data mining is a serious issue and investors need to be very How do you engage with clients about smart beta – is there any interest and if there is interest do clients raise any concerns?

Frankly, it has been very challenging explaining smart beta to our clients, but since our usage is limited it is not something that clients raise concerns about. Given the current environment interest has been limited.

Are there any specific areas where you would like to see new products emerge?

The biggest gap in my opinion is the lack of long-short strategies. Smart beta ETFs have typically been long only and if you look at performance a lot of it comes from market beta exposure.

Factors essentially are long-short portfolios and would be good to have products that do not carry market risk and are able to capture pure alpha from a factor. These can potentially act as absolute return strategies that would fit extremely well in a multi-asset portfolio.

Does multi-factor investing interest you?

Multi-factor products are great for investors wanting to simply add factor-based strategies to the portfolio mix but we normally prefer single-factor products. We consider single factor ETFs as precision tools to adjust the overall factor exposure in the portfolio.

With single-factor ETFs we can target specific factors that a portfolio may be missing out on. Multi-factor ETFs on the other hand tend to simply increase factor exposure across all factors and in some cases, portfolios can end up overexposed to a specific factor by doubling up on it from elsewhere.

Therefore, our preference has mainly been for single factor products as they tend to give us more control during portfolio construction compared to a multi-factor strategy.

By 2025 do you think you will be making extensive use of smart beta products and factor ETFs?

We believe our usage of thematic products may increase over the coming years but factor-based strategies would mainly be driven by market conditions. Our adoption would increase if we saw more of long-short type products in the marketplace. careful when investing in such strategies.

Due diligence and research are key to understanding how the index is constructed to ensure that the factor exposures are genuine and academically proven.

Having seen the quant hedge fund world, data mining is a much bigger issue out there than compared to ETFs which track indices from reputed index providers.

This article first appeared in the Q1 2021 edition of Beyond Beta, the world’s only factor investing publication. To receive a full copy, click here.