Michael Hunstad 
With the help of a cute new name – ‘smart beta’ – engineering portfolios to systematically invest according to various factors has captured the attention of investors, both large and small, in the past few years. Now, that attention is getting seriously analytical, according to one of the big providers in the field, Northern Trust Asset Management.
Northern Trust published a paper in July called ‘Choosing a Smart Beta Factor – Not Which, But When’, which analyses the cycles of the major factors. Size, value and momentum, for instance, tend to have a longer cycle than low volatility to deliver the desired outcomes.
The firm is also about to publish another paper which illustrates the stark differences between the Australian share market and other major markets when it comes to factor investing. Taken together, the research pieces indicate an Australian factor investor is probably best off investing globally and, then, should be aware that a blended factor portfolio will offer downside protection from factor cycles.
Northern Trust’s quantitative research unit calculated that, for US Russell 3000 stocks, low volatility index funds have a cycle length of only about 12 months. Among the other factors, high dividend yield has a cycle of 22 months, high momentum of 39 months, high value of 47 months and small size of 106 months.
“One drawback of factor-based investing is that factors can underperform for long periods,” the paper says. It would therefore make sense for investors to focus on cycle lengths les than their investment horizons.
“Tilting toward factors with a longer cycle length exposes the portfolio to the risk of gaining exposure at or near a peak in a factor cycle and being forced to liquidate the portfolio before the cycle completes and the factor can fully recover… As our new research has shown, investors may need to take another dimension into account in their investment decision-making process. Rather than focusing just on which factors, when is an important component of the decision as well.”
Michael Hunstad, the director of quantitative research, said on a regular visit to Australia from the US last week that Australia was one country where he was less certain about the sustained characteristics of certain factors, such as size. “Australian factors don’t behave like the rest of the developed world,” he said. “There’s a lot of concentration, companies tend to pay high dividends and smaller companies have a higher exposure to commodities.”
The MSCI World large-cap stocks returned an average 4.7 per cent a year between 2000-2015 compared with 10.6 per cent for MSCI World small caps. By contrast, ASX 300 large caps returned 9.0 per cent over the same period against small-cap returns of 5.4 per cent.
He said that macro-economic effects, such as commodity prices and the acceleration of GDP growth in China, had bigger impacts on Australian equities than other equity markets. Factor spreads were more highly correlated in Australia, with long-term difference between low volatility, high quality and high dividend-yielding stocks. Behavioural factors also tend to have less effect in Australia than elsewhere.
Bert Rebelo, Northern’s Asia Pacific director of product management, said that investors were doing a lot more rigorous analysis of factor investing. While Northern would construct an Australian engineered equity portfolio if asked to do so, most super funds were interested in the global strategies.