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Factor investing, smart beta, or the new age way

This article was first published on New Age Alpha

Every day a new investment firm claims they are trailblazing the area that lies between passive management and active management. Seeing themselves as cowboys who are discovering the Grand Canyon for the first time, they ride in with all kinds of new overlays or secret filters to spot stock market winners. What they don’t realise, however, is that the Grand Canyon is both very old and very wide. So chances are good that their discovery is not quite as “new” as they think. In order to discover something new, one needs to take an entirely different approach — such as not attempting to pick winners in the first place!

Out with the old. In with the…old?

It’s said that, if approached correctly, investors can attain some of the key advantages of active management while also garnering some of the benefits of passive management. Some call such an approach factor-driven investing, others call it Smart Beta, and still, others use very specific overlay approaches to reap these benefits. Defining the advantages and benefits of the respective spectrum ends is easy. A unified definition of this area between the two, however, remains elusive.

We believe this gulf has proven to be a boon for factor-based investment managers expressly due to the area’s ill-defined nature. Eugene Fama and Kenneth French’s initial three-factor regression model was academic and precise. Let’s be clear on that. In practice on the Street, however, it — and other factors and/or Smart Beta applications — has resulted in an excess of stock picking models, each more arcane than the last. Yet, seemingly, virtually nothing changes. Investors and plan sponsors are left to read tea leaves like a medieval seer to deduce if a portfolio manager’s methods are revolutionary or merely lucky.

New investment approach for a new age

The respective benefits of active and passive management are well known. Active management — also known as direct stock picking and/or market timing — claims to offer better performance, particularly when the market swoons. Whereas passive management — also known as index investing — offers comparable market exposure but with lower fees. Many firms claim to harness the best of both worlds by creating rule-based products that, nonetheless, still pick stock market winners.

We might argue, however, that this is the worst of both worlds.

You see, we believe that any of these approaches still rely on picking winners. However, this requires the ability to forecast the future, which is impossible. And firms are charging greater fees than their passively-managed counterparts despite persistent underperformance.

At Global and Local Asset Management, we believe all risk originates from human behaviour. When humans interpret vague and ambiguous information in a systematically incorrect way, it gets impounded into a company’s stock price. This creates a type of idiosyncratic risk distinct from traditional “firm specific” risk, that may impact stock prices and we believe cannot be diversified away. Specifically, this type of idiosyncratic risk is unique to the stock itself, as opposed to the firm as a whole. To mitigate this risk, we use New Age Alpha’s Human Factor Tool which calculates a stock’s Human Factor – the likelihood that a company will fail to deliver the growth implied by the stock price. We don’t attempt to pick winners, we simply aim to avoid the losers. And unlike a traditional portfolio manager, we take an actuarial-based approach to managing risk. We focus only on the known, rather than the unknown.

Avoid the losers

Global and Local Asset Management, through the use of the Human Factor, seeks to outperform without increasing exposure to widely recognised risk factors such as size, value, or momentum. This is because, if one defines factor-based investing or Smart Beta as enhanced passive management, we are decidedly not that. By measuring and avoiding human behaviour, we are not handcuffed by the rigidity of a benchmark. In most portfolio managers’ attempts to create outperformance, they select the same stocks as the benchmark but simply weight them differently. Our approach isn’t nearly so limited. This results in portfolio options that have not only historically outperformed but have done so without significant correlation to the components of other widely used benchmarks.

Compare this to an old-world marinara sauce. Many, if not most, red sauces use tomatoes as their central component — not unlike most investment products that originate from the same indexes. But, while a well-made red sauce is exquisite, some sauces are little more than ketchup. We’re not here to cast aspersions on a time-tested, classic dish. But rather, we’ll point out a pesto sauce can provide a rich, luxuriant dinner whose source ingredient is unique.

Taking this one step further: We are not concerned with beta, like so many Smart Beta shops. And we certainly don’t target a beta of 1. We view beta as simply another age-old metric that is, itself, rooted in human behaviour. After all, beta is a reflection of market price movement, and our position is that market prices are ultimately determined by humans. Also, implicit in traditional Smart Beta strategies is the notion that the beta of a portfolio will be no different than that of the universe and outperformance will result from successful stock selection. In contrast, however, our portfolios may have a beta less than 1 even as they may outperform on a relative basis.

Another key way in which this approach is distinct from Smart Beta or factor-driven strategies is its relationship with specific factors. Of the commonly used factors, those that best explain performance are profitability (return on equity) and quality (debt-to-equity). Yet these are calculated exclusively from financial statements — the exact process we use to avoid the risk of human behaviour. Meanwhile, we believe factors such as volatility and value are least predictive of performance and, not coincidentally, rooted in human behaviour.

Fundamentally, we believe that any of these strategies falter because — above and beyond the impracticality of picking stock market winners — they’re focusing on metrics that are merely symptoms of the overall risk of human behaviour. Factors, beta, volatility…any of these are simply different manifestations of the same problem.

It’s similar to that old parable about the blind men describing an elephant based on their sense of touch. One man feels the elephant’s tail and proclaims the elephant is exactly like a snake. Another grasps its leg and compares it to a tree. A third touches the ear and says an elephant is a giant leaf. None of the men are wrong, precisely. But they’re most certainly not correct. And it all comes back to perception.

The aggregate effect of all behaviours

History can be the greatest guide of all. As so often said, those who can’t remember it are doomed to repeat it. So why do so many portfolio managers continue to enact strategies — factor-based, Smart Beta or otherwise — that rely on picking stock market winners when they should simply avoid the losers?

About Us

At Global and Local Asset Management we firmly believe in stripping out all vague and ambiguous information from the investment process. This is why we use New Age Alpha’s developed system called Avoid the Human Factor (H-Factor). The H-Factor measures the probability a company will fail to deliver the growth implied by the stock price. This risk is caused by investors interpreting vague and ambiguous information and impounding it into a stock’s price in a systematically incorrect way. The lower the Human Factor, the more likely vague and ambiguous information has NOT been priced into the stock. The H-Factor System is a free comprehensive portfolio tool that enables investors to apply our Human Factor metric to over 6 000 stocks, ETFs, global indexes, and their own portfolios.

New Age Alpha is a global leader in building actuarial-based asset management solutions that aim to protect investor portfolios against this idiosyncratic risk caused by human behaviour. Investors are unaware of this risk that leads to loss, cannot be diversified away, and don’t get rewarded for taking it. Unlike firm-specific risk, which can often be diversified away, this risk affects stock prices specifically and we believe is caused by human behaviour. Through New Age Alpha’s research, they have identified a differentiated source of alpha that is uncorrelated with traditional risk factors and managers, and as the foundation of their investment approach, they have built a range of actuarial-based asset management solutions that aim to mitigate the risk of human behaviour.

If you would like to know more about how the Human-Factor score tool works and how we “Avoid the Losers”, then please contact us at Global & Local Asset Management.

Disclosures

Global & Local Investment Advisors (Pty) Ltd is a registered financial services provider in terms of the Financial Advisors and Intermediary Services Act (FAIS). Global & Local Investment Advisors (Pty) Ltd holds FSP license number 43286.

Global & Local Asset Management (Pty) Ltd. Reg. Number: 2018/580284/07

Global & Local Asset Management is an authorised juristic representative of Global & Local Investment Advisors (PTY) Ltd FSCA License Number: 43286

Any investment performance figures quoted herein are for illustrative purposes only and should not be construed as investment advice.

Investment advice can be provided by Global & local Investment Advisors (Pty) Ltd but only after an analysis has been conducted of the investor’s current financial circumstances and investment portfolio, only then will a recommendation be provided based on that investor’s own circumstances by Global & Local Investment Advisors (Pty) Ltd.

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Investment advice is offered through New Age Alpha Advisors, LLC a wholly-owned subsidiary of New Age Alpha LLC.

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