Factor-Based Strategies

Passive Investing Alternatives

Pure passive equity investing involves purchasing and holding an index to replicate its performance at a minimal cost. The cost element is crucial – excessive expenses in replication can negatively impact returns over the long term. Larger indexes require purchasing more securities for replication, leading to higher transaction costs.

Smart Beta

Achieving 100% index replication can be expensive. Managers often opt for partial replication to lower costs. Smart beta aims to replicate index performance by identifying key risk factors within the index and creating a portfolio that mirrors these factors. This strategy reduces costs by allowing more flexibility in portfolio assembly. If the risk factors are aligned properly between the portfolio and the index, similar performance can be achieved.

Common Equity Risk Factors

Growth: Associated with high-performing companies and above-average earnings growth, often having a high price-to-earnings ratio.

Value: Linked to mature companies with stable earnings or temporary declines. Value stocks usually have low price-to-book and price-to-earnings ratios, along with higher dividend yields.

Size: Involves purchasing low float-adjusted market capitalization stocks, capitalizing on the size premium, where small-cap stocks tend to outperform large-cap stocks.

Yield: Firms with high dividend yields outperform lower-yielding firms in low-interest-rate environments.

Momentum: Captures returns from stocks with above-average price increases in the prior period.

Quality: Involves stocks with growing dividend payouts, earnings, excellent cash flow to earnings, and low debt-to-equity ratios.

Volatility: Volatility diminishes long-term returns and is avoided by long-term investors. Short-term traders might use volatile stocks. Volatility measures include standard deviation, variance, downside deviation, and VaR, among others.

Passive Factor-based Strategies

Passive factor-based strategies often involve the rotation of factors based on their level of exploitation, aiming to generate excess returns. These strategies are also used in a more passive manner. There are three primary passive factors that portfolio managers can consider:

Return-oriented

This approach uses fundamental information to select securities with characteristics such as higher dividend yields, current price momentum, or favorable fundamental factors such as low price-to-earnings ratios.

Risk-oriented

Risk-oriented strategies focus on quantifying the impact of adding specific securities to a portfolio on risk metrics. For instance, volatility-weighting assigns higher weights to less volatile securities. Minimum Variance Optimization is another risk-oriented approach that aims to minimize portfolio standard deviation while satisfying constraints.

Diversification-oriented

This approach includes equivalent-weighted portfolios and maximum diversification strategies. Passive factor approaches offer cost savings compared to active management. They facilitate passive investing and allow expressing market views, but they are still costlier than pure indexing.

Question

Which of the following management styles is considered to be a middle ground in terms of cost?

1. Smart-beta.
2. Pure indexing.
3. Active management.

Solution

The correct answer is B.

Pure indexing, often referred to as passive management or index investing, is considered to be a middle ground in terms of cost. This management style aims to replicate the performance of a specific market index, such as the S&P 500, by holding a portfolio of assets that closely mirrors the index's composition. The primary goal of pure indexing is to match the returns of the chosen index, not to outperform it. Because it involves minimal trading and research, it typically has lower management fees and operating costs compared to active management.

A is incorrect. Smart-beta strategies are a type of passive investment that falls between pure indexing and active management. These strategies aim to enhance returns or reduce risk relative to traditional market-capitalization-weighted indexes by using alternative weighting schemes or factors. While they may have slightly higher costs than pure indexing due to the complexity of their strategy, they are not considered the middle ground in terms of cost.

C is incorrect. Active management involves portfolio managers making buy and sell decisions to try to outperform a market index or benchmark. This style typically has higher costs compared to passive management (both pure indexing and smart-beta), as it involves research, analysis, and frequent trading. Active management strategies often come with higher management fees and expense ratios. 

Reading 24: Passive Equity Investing

Los 24 (b) Compare passive factor-based strategies to market-capitalization-weighted indexing