Putting Factors to Work

Innovation is key...

Now that we've agreed factors (defined here) are the way of the future, it is important to understand how to implement them in a portfolio.

The investment industry has changed dramatically over the last few decades. Technology and data allow us to access information ever more quickly and easily. In the past, we needed humans to identify companies with low P/E ratios (value companies) or high return-on-equity (quality companies). Now, technology allows us to screen for that information and using technology instead of humans to find the companies we want means two things: (1) finding them becomes significantly cheaper and (2) the ones we find are based on fact, not emotion or judgement. All of this evolution in data availability and technology leads to a couple of important innovations:

Factor indexing: Once the sole province of "markets" (i.e. the S&P 500 or Dow Jones Industrials), indexes can now be created for a wide variety of investment parameters. For example, if an investor wanted to own all of the stocks in the S&P 500, but wanted greater exposure to cheap companies, the investor could simply re-rank all of the stocks in the index so that the most heavily weighted ones were those with low P/E ratios instead of the highest market capitalization (shares outstanding x share price). The fact that this is done without a portfolio manager makes the stocks cheaper to find, objective rather than subjective, and much better diversified. Learn more about factor indexing here.

ETFs: Now that we have selected the stocks we want to own (and how we want to own them), we'll need an investment vehicle to hold them. Enter the Exchange Traded Fund, or ETF. We emphasize ETFs over traditional mutual funds for a number of reasons: (1) they are lower cost due to the elimination of some key administrative and distribution costs of mutual funds; (2) provided they are index-based and not active, they distribute low or no capital gains. A third benefit is potentially their liquidity, meaning they trade on an exchange like a stock and therefore an investor can move in and out of them any time during the day instead of waiting for orders to go through at the end of the day like a mutual fund. However, this entails risks: small, illiquid ETFs must be traded carefully just like if one was buying or selling a small cap stock.  Furthermore, the fact that they trade on an exchange means they have a market price that can deviate from the underlying value of the securities in the portfolio (NAV). This is less of an issue for large, liquid ETFs, generally speaking. At Metric, we do not value this third trait as much as the other two since we are buy-and-hold investors.

So when we put these two things together, we get a huge benefit to investors: a way of capturing (or perhaps even improving upon) the potential outperformance of traditional active managers at significantly reduced cost in a vehicle that offers tax benefits.