57. Using Factors to Invest Smarter

Transcript:

Evan Neufeld: Hello, and welcome back to the Canadian Money Roadmap podcast. I'm your host, Evan Neufeld.  On today's episode, we are talking about factor investing. It's not passive, it's not active, it's somewhere in between and it's something a little bit different. Jordan, it's good to see you. You're feeling a little bit better?

Jordan Arndt: Feeling better, things are good. Things are looking up. 

Evan Neufeld: You're on the right side of the bed. Well, thanks so much for joining us today. If this is the first time listening to the podcast, if you like what you hear today, hit follow and you'll get a new episode every couple of weeks. We've been focusing more on some investing specific topics lately on the podcast. And on the last episode, I was talking about “the market”, understanding the market in general and specifically the stock market, of course. And when one invests in the market, you kind of get a little bit of the good, a little bit of the bad, you get the average.  But the nice thing is that the average is pretty good over time.  So when we talk about investing in the market, I'm going to introduce a term here that might come up, might not, but just so that we're all on the same page. When we talk about market returns, we use a Greek letter called beta. So when we talk about beta, that means essentially, the risk level of the market and the return level of the market.

 So when you're investing in stocks, if you're using what we call a passive strategy, where you just buy the market, you're investing with the goal of getting just the beta.  Now with an active strategy, that means that there's typically a manager or a team of managers that are buying and selling stocks. They're hoping to get what we call alpha, so that means performance above what the market would get, so better than the market. Now, sometimes that's possible. In many cases, it's really difficult to do largely in part because of the additional fees that are charged with active strategies and there's many people that try to do it. So on aggregate, it can be very, very difficult to actually outperform the market and get that alpha. So our topic for today is something a little bit different that sits in the middle between passive/beta and active/alpha. And we call it factor based investing and the reason I brought it in those Greek letters there is because sometimes factor-based investing is called smart beta. So if you've ever heard that term before, what it's referring to is factor based investing. Jordan, do you want to give us a brief overview of what is factor investing.

Jordan Arndt: Yeah, it's something that's really well backed up by research. Think of that more of as a quantitative evidence based strategy. So factors are different style factors and we'll get into what those are. This sounds like nerd stuff. Yeah. It's this is a little bit more nerdy for sure. But really it's just a characteristic that you can apply to a stock or a group of stocks, that group is going to exhibit certain risk and return features.  So factor based investing strategies often, like you mentioned, is computer based, keeping those fees a little bit lower than an active strategy. Typically we'll look for securities or stocks that exhibit the characteristics of that factor. Let's maybe just use a quick example when that makes sense.  So size factor, you've maybe heard of, small cap, midcap, large cap stocks size factor tends to look for companies that are more on the smaller size, so smaller cap stocks. Again, we'll dig into that further, but really it's just the size is the factor style. That those stocks that fit within it will all exhibit similar characteristics on a risk and return basis.

Evan Neufeld: So a company like apple is two and a half trillion dollars or whatever it is today, large cap. So it would not have the size factor as part of its characteristics. This is really interesting to me because the style of investing, it's not completely passive, it's not completely active. It's what I've often seen it called as rules based. And so behind the scenes when you have a mutual fund or an ETF that invests specifically in factors, they set up rules for their fund to only look at these stocks and then reduce them by any number of characteristics, specifically, these individual factors. Do each of these factors that we're talking about actually increase returns or what's kind of the main point here Jordan. 

Jordan Arndt: Yeah, I think that's like why would we want these factors? And I think that's going to come down to the individual investor and what their timeline is, what their investment objectives are. Yes, there is some evidence based to suggest that these factors do increase performance when used correctly but they also can be used to reduce risk. So as you were just mentioning low volatility, that's going to have a bit more of a stable earnings return, that can reduce the risk.  It can also help you achieve desired investment. Dividend yield might be returning more income back to you as an investor. If that's the strategy or outcome you're looking for. So it's hard to say why one one would use this, it's going to be personal for sure. But there is evidence behind it to say that tilting towards certain factors either can improve returns, reduce risk, improve risk adjusted returns.  Do you have anything else that you'd add to that? 

Evan Neufeld: Let's just talk about risk for a second. Usually when we talk about risk, we just talk about volatility of prices. So the prices moving from really negative to really positive.

Just for an example here, we have two hypothetical investments. Each of them on average has returned 6% on average. However one has a standard deviation. So that's the, the metric we use for determining risk.  So standard deviation just gives you the range of expected outcomes. So 6% average, but a standard deviation of 10%. So what does that mean? That means that most of the time, you can expect this investment to give you a return anywhere between minus 14 and positive 26. Okay. Pretty significant range. Right?

So if you get a positive 26 and a positive 18 back to back, you're like, oh my goodness, this is huge. But then next year's minus 14 or whatever the case may be all to average about 6%. Now, hypothetically again, an investment could still average 6%, but have a 20% standard deviation. In this case, the range of expected outcomes for that investment would be minus 34 up to positive 46 -  huge range, massive range, but the same average.

So which investment is “better”? Well, tough to say necessarily, but the first one can get the same average with less risk, less of a bumpy ride. Based on what we've seen here this year, markets have been pretty volatile, mostly to the downside. And for many people having a lower standard deviation or lower volatility is actually quite top of mind.

So digging into the research on this a little bit. We're not going to get into all of the academia. There's a number of great podcasts out there. If you want to make your brain explode, that dig into this a lot more and from people that are much smarter than me, but I'm going to give a brief overview today of just what these things are and then maybe in future episodes, we can dig into them a little bit more.  Or at least there'll be a bit more familiarity with them when we do discuss them again in the future. There's a lot of research that says there are this many factors and then years later another researcher comes along and says, well, actually we've discovered some other factors.  And then other ones will be like, well, no, that's actually just an overlap of these ones. We're not going to get into the minutia of determining what has the most evidence or anything like, but we're going to talk about six common style factors ones that we've seen that are, that are quite prevalent anyways.

But let's start with dividend yield. This is a factor related to dividend paying companies. If you go back and listen to our podcast on dividends. We'll explain what dividend yield is, but yeah, Jordan, maybe walk me through this one here.

Jordan Arndt: Sure, really it’s just that factor is seeking excess returns from stocks that have higher than average dividend yields.  So maybe just use some hypothetical numbers, if the total market per se has a yield of 1%, for example, this factor's going to try and tilt towards companies that have yields that are higher than that. So maybe the dividend yield factor collection of stocks might have a yield of two and a half percent, or the numbers don't really matter here, but just that it's seeking companies that are offering that higher dividend yield.

Evan Neufeld: Does that mean the highest dividend yields? Not necessarily, no. It's it is higher than average, higher than average. Yeah, exactly. And so there, there can be risks that we discussed on that episode of, of going after only the highest, but this would be companies that pay higher than average dividends. So that's an interesting one. Another one here, that might be top of mind for maybe retirees or people that are getting closer to retirement, maybe more conservative investors, low volatility. So this is a factor that targets stocks with lower risk than the broader market and typically more stable earnings, more stable cash flows, things like that.  It hasn't shown necessarily to increase absolute returns over time, but it has allowed for market-like returns, but with lower volatility than the average market. 

Jordan Arndt: And so depending on where you are in your investing journey, that can be a great factor to have exposure to for sure.  Again, not for everyone necessarily, but needs to be considered in your larger picture. 

Evan Neufeld: Next one, some evidence that I've seen has seen these two factors here overlap a little bit. But this one is quality. I always think that the name quality is funny. 

Jordan Arndt: It's like, why wouldn't I want quality companies?  I don't want bad companies.

Evan Neufeld: Exactly. So these ones, when we talk about quality, it's more about profitability, cash flows, not a lot of debt. When they borrow money, they get lower rates than average. Boy, that sounds pretty good. You know, when you talk about all these factors like yeah, all these make logical sense too. It's not just academic sense in my mind. So quality, let's contrast that with a company. Like I hate to always pick on Tesla, but most people understand Tesla. Cool company, cool cars, lots of growth potential, stable cash flows, lots of profit, lack of debt.  You know, these are not factors, not how you describe Tesla. That's not how you describe Tesla. So a quality company, again, I hate to always mention apple, but again, it's one that people know that is a company that has a, a pretty significant quality factor present in it. So this strategy would be trying to avoid up and coming companies, new technologies, things that are top of the new cycle, a bit more boring, more established companies.

Jordan Arndt: And often going hand in hand with that low volatility, right? Like you talked about.

Evan Neufeld: Okay. Let's flip this on its head and here's another factor and maybe that this one contrasts a little bit, but momentum. 

Jordan Arndt: Yeah, that one's interesting. So that's really, you know, looking for stocks that are recently outperforming and you think we'll continue to do that over the short to medium term.  Really, it's just trying to take advantage of price trends. So if a stock is you know, if the price is increasing, momentum factor would say, well, it's over the next short to medium term, it's going to continue to increase and let's not for lack of a better word, get in the way of that. You know, take advantage of that momentum that you're seeing with a certain stock.

Evan Neufeld: Maybe I'll just add a little bit of opinion on this one, but when it comes to momentum, as we've seen just in the last couple of years. The things that have worked, have gone from not profitable tech to oil and gas, like, it's not a complete binary there, but so for a momentum rules based strategy to work, it requires a lot of trading and typically the cost to do so is a little bit higher then average. And so these funds are moving, like there is a lot of buying, a lot of selling back and forth because stocks move all the time and the markets move and preferences move. 

Jordan Arndt: And it's specifically talking about a shorter timeframe as opposed to saying, well, Apple's a good company today and we think it'll be a good company in 10 years from now.  And so it's, you know, buy and hold for a longer term. That's not what momentum is saying, it's trying to capture those shorter term price trends in the positive direction.

Evan Neufeld: And it's a little bit different too because it's not looking at the quality of the company, the quality of the business, cash flows or anything like that.  It's just like, oh, stocks that are going up will probably keep going up for at least a little bit. 

Jordan Arndt: So you got to know when to get off that train, right?

Evan Neufeld: So a rules based strategy is probably a good way to implement this as opposed to the day trader philosophy of get in, get out, get in, get out.  Yeah, perhaps a rules-based strategy if you're a momentum investor.  To me, this one is probably the least compelling. As far as being able to replicate it on a consistent basis.  Okay. Here's another factor that is a little bit easier to understand much like low volatility and quality. This one is called value. So value is looking for lower cost stocks that are undervalued relative to their intrinsic value. What's intrinsic value, Jordan?

Jordan Arndt: Intrinsic value is just really what an asset, a company, a stock is really worth. So if you think the intrinsic value of a stock is $20 per share, but it's currently trading at 15, you would say that that stock is currently priced under what its intrinsic value is worth.  So you'd call it a value stock. 

Evan Neufeld: And to me that's pretty compelling. 

Jordan Arndt: Yeah. If you think it's worth $20 for whatever reason and you can buy it today at 15. Yeah. If your thesis is good for why it's worth $20, that that seems like a great idea. 

Evan Neufeld: Jordan. Let's do a little value analogy here. I'm a basketball fan. In the last episode, I gave a basketball analogy. Maybe I'll give a basketball analogy in every episode now. My favorite NBA player of all time. Do you know who it is, Jordan? 

Jordan Arndt: The guy who was in Hustle on Netflix.

Evan Neufeld: Juancho Hernangomez? No, not him. Manu Ginóbili, do you know Manu Ginóbili? He was just inducted into the hall of fame. We're in September here, this was just this past weekend. But he was, I think, criminally underrated. I think he was drafted like 57th or 59th or something like that. Only two rounds in the NBA draft, right at the end. No one was looking at him. No one cared. Argentinian player, no one scouting this guy, got him for cheap. That's right. Got him off the bottom. Just took a flyer on him and throughout his long NBA career, he came off the bench in about 70% of all of his games. So he wasn't making the headlines or anything like that.  He was a bench player, but his coach, Greg Popovich, one of my favorite basketball personalities too. He knew how to use him in key moments. At certain times, he put him in to have massive impact, not for 40 minutes a night but in shorter spurts for specific things. And he ended up making two all star teams, winning four NBA championships.  They beat the USA in the Olympics in 2004, and he was the MVP of the Argentinian gold medal Olympic team. And he was a hall of Famer for a bench player. He's a value guy, for sure. So I think a value investor should love a guy like Manu Ginóbili. Value investing isn't the rookie of the year.  It's not the LeBron James. Could you call it the underdog? Yeah, it is a little bit of an underdog story. There we go. Nice. Anyways, that's my little aside for value there. And the last one, the last factor that we touched on already was size. So this is looking at small companies outperforming large companies over time. Now there has been a little bit of update to this research too that, I don't know, maybe we can discuss a little bit, but to me it makes a lot of sense. So for small companies, their growth potential makes good logical sense, right? If they're new, they only have one way to go unless they go bankrupt. Right? So because they're small, they have a lot more growth potential. Is Coca-Cola going to start selling hundreds of millions of bottles more of Coke. No, they've been around for 130 years or whatever it is. They're not going to just suddenly keep growing. But you know, a company like Squarespace, I use them to build my website,  they're relatively new and relatively new in the public markets. They have a lot of growth potential hypothetically. Does that mean that Squarespace is a great investment, not necessarily. So this is where the discrepancy comes in on the size factor exclusively. So there's a bit more research that has said that it's not just size or small companies that outperform, it's profitable, small companies that outperform.  And so by pairing some of these factors together, you can actually improve the relative performance of each factor. 

Jordan Arndt: And historically speaking, that's been size and value, right. Tends to combined, perhaps if you have a tilt towards that, perhaps you'll, I'll perform a broader market in general with increased risk though, or volatility.

Evan Neufeld: Those are two factors that don't decrease your risk, but they increase your return expectations. 

Jordan Arndt: So not for everyone. But historically, evidence based, those have been factors that have outperformed. 

Evan Neufeld: Right. Now, when we talk about outperforming, decreasing risk and things like that, we always have to clarify that this is over a long period of time and over many decades. Because you know, there have been periods of time where bonds have outperformed stocks, but that doesn't mean that stocks don't outperform over a much longer period of time, right? And so each of these factors will have desert seasons, if you will. 

Jordan Arndt: There's an interesting chart. And again, hard to see on a podcast here like this, but it shows the factors that have each calendar year, those that have been kind of the top performing factor and those then down to the least performing factor and comparison to the broader market in general.  And it changes every year, right? Size is not the best performer every single year, some years it is and some years it's the worst. And so, yeah, I guess just consider that value and size does not mean best performance every year, moving forward and outperformance compared to the broader market, by no means.

Evan Neufeld: Yeah. So looking forward using the evidence to guide our decisions today, to reduce emotions and things like that, that would be the factor strategy, right? So the pure active strategy says, well, let's look at the new cycle. Let's see what the prices are doing today. Buy, sell, buy, sell.   Passive says, I don't care what's happening ever, I'm just going to buy everything and get average. But this factor based smart beta tilt or strategy says we can do a little bit better than that. Than each of them, either by decreasing costs, getting emotions out of it, looking for the parts of the market that have been better over a long period of time.  To me, factor based investing is pretty compelling, but like you said, it's not for everyone mostly because it's hard to do. 

Jordan Arndt: Specifically as an investor, you need to start thinking about, okay, how am I going to actually incorporate this information to construct an investment portfolio?  A couple of ways, maybe are a strategic exposure. So I'm going to have a slightly greater tilt to just pick one low volatility as compared to the broader market. You know, fair enough. Considering your timeline, goals, risk capacity, tolerance, all that sort of stuff. So, you know yeah. As you think about it's like, okay, how am I going to actually incorporate this information to achieve my investment objectives. 

Evan Neufeld: Another way you could look at it would be through cyclical exposure. So assuming there is a business cyclone, maybe we could have a whole podcast on that specifically, but recession is the big word that people are thinking of now. In a recession, are growth stocks going to be highly valuable when interest rates are high. No, it just doesn't make logical sense, right. So a factor that typically does well in a recessionary environment could be those low volatility, high quality stocks. 

Jordan Arndt: And then as we come out of that recession, that changes.

Evan Neufeld: Kind of flips a little bit. Yeah, exactly.  So trying to time factors can be really challenging, but if that's something you want to do, like this is a decent way to do it. That buys groupings of companies as opposed to individual securities as well. 

Jordan Arndt: I think at its core, factor investing evidence based, which is good, not emotional, not emotional decision making.  And it has the opportunity to increase performance, reduce your risk and achieve your desired outcomes.  That's not prescriptive for everyone right, but it has the opportunity or the ability to create some benefits for you. 

Evan Neufeld: Absolutely. Well, that's our brief overview of factor investing.

If you have questions about this, feel free to shoot us an email and I'd love to have a brief email conversation with you. Again, if you haven't subscribed or followed the podcast in apple podcast or Spotify, wherever you're listening. We'd love to have you along for future episodes, but thanks again for listening and we'll see you in a couple weeks.

Thanks for listening to this episode of the Canadian Money Roadmap podcast. Any rates of return or investments discussed are historical or hypothetical and are intended to be used for educational purposes only. You should always consult with your financial, legal and tax advisors before making changes to your financial plan. Evan Neufeld is a Certified Financial Planner and registered investment fund advisor mutual funds and ETFs are provided by Sterling Mutuals Inc.