ETF Stream’s deputy editor Tom Eckett speaks to Sandaire’s investment director Oliver Smith on his approach to factor investing, smart beta within fixed income and the reasons for avoiding multi-factor products.
Smith joined Sandaire in November 2019 from IG where he was a portfolio manager for three years. In 2019, he was named in ETF Stream's inaugural Industry 30.
Tom Eckett: Do you use smart beta or factor products within your clients’ portfolios?
Oliver Smith: Yes we do. We find them an effective way to diversify asset allocations and to target parts of the market with a focused lower-cost solution.
Investors are now quite well served with competing products from a number of asset management businesses.
How much of your portfolios does smart beta typically make up?
Within the equity allocation we have around 20% in smart beta, which probably marks the highpoint.
However, factor exposures are a major determinant of how we allocate to managers and we can analyse this quite closely with both Morningstar style grids and factor analysis tools from software providers.
How do you view smart beta/factor-based ETFs?
I see them as a complement to our actively managed funds. Factor ETFs offer a low-cost way to get diversified stock exposure, and a purer factor tilt.
For example, you could buy a value-tilted active manager but their stock risk may be higher than benchmark. Combining both the active and passive managers can help to improve the portfolio’s overall shape.
If you had to identify one factor that is really compelling what would it be?
Everyone is waiting for the turn in value vs growth and whether you are overweight growth or value, the extent of growth’s outperformance has been astonishing over the past 12 months at almost 30%.
Much of this has been due to changes in valuation rather than earnings growth, but it is also true that growth stocks tend to have more robust balance sheets and in this economic shock businesses with balance sheets that are net cash or very lowly geared are going to emerge stronger than their competitors.
Value will have its day in the sun, and we have made tentative steps to reduce our growth overweight, but it will take an improvement in consumer confidence and an uplift in inflation expectations for market leadership to change.
What factors do you take into account when selecting a smart beta product?
First, you want to have a meaningful tracking error, otherwise there is little point in owning the product.
Second, both liquidity and ETF size are important areas of consideration. The latter is especially relevant for investors with tax considerations; the last thing people want is to be presented with an extra tax bill if an investment is wound down.
It always makes due diligence easier if a product is developed by an established provider, but we can and will make that effort to analyse new investments from less known houses.
Are thematic ETFs something that interest you?
It is something we are looking at. The dispersion in returns amongst sectors has been great year-to-date and a thematic ETF that takes elements of those sectors could work.
That said, the danger of buying thematic investments is the risk that you are their factor risk when compared with a market cap simply chasing the latest hot stocks.
However, post the March sell-off we have found that our active managers have been nimble enough to take advantage of the opportunities that have performed well during the lock-down, and their more selective approach can, I believe, be more effective than a broader-based ETF where often the top 10 holdings are quite concentrated and you will inevitably end up owning businesses that you can feel uncomfortable with from a valuation perspective.
Is data mining a key concern when using factors?
If you are continually trying to discover new factors, you are probably data mining. There is also a risk – which Research Affiliates and other strategists have identified – that longer-term factor outperformance can be substantially driven by valuation changes.
This calls into question the robustness of factors. However, we do not own factors for this purpose; our view is that they can add diversification to portfolios and they are also a useful tool for looking opportunities within a market cap index.
How do you engage with clients about smart beta?
We would not refer to ‘smart beta’ per se, but clients are interested, and always have been interested, in the drivers of market performance, whether that is small cap, momentum or value. We have conversations around this regularly.
Are there any specific areas where you would like to see new products emerge?
Overall, we are very well catered for, but every economic cycle has new winners and there will be ongoing demand for new products as these start to emerge in this fresh economic environment.
With regards to fixed income, to generate a meaningful tracking error, you need to take substantial active positions vs your index.
Duration and credit risk have always been the two key levers of fixed income investing, and I think it is unlikely that we would be able to take large enough factor-exposed positions to make this worthwhile.
Does multi-factor investing interest you?
Not especially as these are usually based on the premise that a blend of factors will lead to sustainable outperformance of a market cap index. I worry this relies too much on backtesting.
In five years time, do you expect your factor allocation to dramatically increase?
We already use them quite widely and they will continue to be part of the tool kit of market cap ETFs and actively managed funds. Ongoing financial innovation could lead to a transition of actively managed funds to the ETF wrapper – we will see!
Oliver Smith is investment director at Sandaire
This article first appeared in the Q2 2020 edition of Beyond Beta, the world’s only smart beta publication. To receive a full copy, click here.