Gregg Fisher – The Advantage of Multi-Factor Investing
Gregg S. Fisher founded Gerstein Fisher in 1993 based on a vision of offering a quantitative investment management approach grounded in sound economic theory and more efficiently implemented through technology. Today the firm embodies that vision and continues to reflect Gregg’s commitment to ongoing research and quantitative, factor-based investing.
Throughout his career, Gregg has worked to bridge the gap between academic theory and real-world investment practice. He has spearheaded research projects on areas of study including the efficacy of momentum and valuation models, tax-efficient investing, the impact of investor behavior on investment returns, and the persistence of certain investment factors across global equity markets.
I interviewed Gregg last week.
You were one of the first to focus exclusively on multi-factor investing, an approach that is now much more widely used and at the center of the active/passive/smart beta discussion. What is multi-factor investing and how is it implemented in your funds (Multi-Factor Growth Equity, Multi-Factor International Growth and Multi-Factor Global Real Estate)?
Multi-factor investing works by identifying characteristics, or “factors,” of stocks or other securities that research shows explain differences in historical and expected returns. The multi-factor model is actually a straightforward idea: The portfolio return is equal to the risk-free rate, plus factor premiums and exposures, plus what’s left, the residual (or “alpha”).
There are two main theories that explain factor premiums: The efficient market theory offers a risk-based explanation, and behavioral-based theory links some factors to the actions of investors. The risk-based story suggests that equity investors should be rewarded for taking risk in the form of enhanced returns. So as risk ebbs and flows, security returns will fluctuate. The behavioral explanation suggests that investors’ greed and panic causes prices to change due to buying and selling. We don’t take a position on which explanation is right, risk-based or behavioral-based; what we care about is that we have factors that hold up over time based on empirical data.
Which factors and asset classes are providing opportunity in this environment? How do you estimate the expected long-term returns from factors and asset classes?
We recently wrote a short paper on the relative decline in investor interest (measured by returns and market-cap growth) in profitability in recent years. There is a case that (much as in other forms of traditional value-based investing) being comfortable maintaining or shifting exposures into recently out-of-favor factors (small-cap and value stocks in 2017, for example) may be beneficial over the long term.
In estimating long-term expected returns, we use as much historical data as possible without assuming that history will repeat. The recent strong performance of momentum, for example (outperforming by between 5% - 10% in 2017 versus low-momentum stocks), and the long-term ~6% annualized premium momentum has demonstrated over the last 50+ years has to be weighed against its significant downside, where in 2008-2009 for example, it underperformed the general market by 60% or more. In addition, some of the momentum premium can be eaten up by high turnover and trading costs, since it is one of the so-called fast-moving factors.
We think about total portfolios in a holistic way. We advise against chasing performance in asset classes or sectors, which we believe is a poor strategy. Instead, investors should ensure that they have an appropriately diversified portfolio and bear in mind that many equity and REIT market valuations (particularly in the U.S.), after years of strong returns, are quite high, which implies lower expected returns.
As quantitative, multi-factor investors, we are very much focused on risk management. Much as with asset classes, factors (such as value, momentum, size) move in cycles, and our preference is to combine multiple factors for diversification purposes.
What makes your approach different than other multi-factor investors?
There are a number of differences, or ways we stand out. For example, our focus on research and our experience in running factor-based strategies – we are not quantitative factor- based managers because we see it as an emerging space in investing – we have always (for 25 years) built our approach on these theories. In addition, whereas a number of quantitative managers targeted value-factor strategies years ago, we focused on the growth space (domestic and international), along with REITs.
Our discipline in maintaining our strategies for the long-term, across allocation targets and factor exposures is another difference. Our combining of multiple, low- or negative-correlation factors into an integrated set of investment strategies (momentum and value, for example) a subject we have researched heavily, is also unusual. I would add that our flexibility to apply our best thinking and strategies across different asset classes, investor situations, and scales is unique as well.
What do you believe are the advantages of your multi-factor approach?
Ideally, we seek to combine the best elements of traditional indexing (diversification, risk management, consistency of strategy, and modest cost and turnover) and the potential which active managers have always appealed to as their allure – the potential to outperform benchmarks.
Our goal is to deliver investment strategies that are rooted in a disciplined, explainable approach that consistently focuses on characteristics that securities investors own across multiple markets and asset classes. These views have been shaped by both academic and proprietary research. It is our belief that through research we can provide an intelligent alternative to pure active or passive management that balances diversification with the potential for investors to earn a higher expected return than with traditional benchmarks.
How do you recommend advisors use your funds in their clients’ asset allocations?
Our portfolios are designed for advisors to be able to use them as either core components of their equity and real estate exposures (as they are diversified and carefully managed to control active risk versus benchmarks) or as complements to an existing suite of managers / investment vehicles.
Our funds and strategies offer a good complement to either index-heavy or more active manager styles.
Has factor-based investing become a commodity? For example, Goldman Sachs has a large-cap smart-beta ETF (GSLC) with an expense ratio of 0.09%. How should advisors view the expense ratio in the context of their fund-selection decisions?
Financial services have all become commodities to an extent – it’s not shocking that quantitative factor- based investing seems to be following a similar trajectory. That said, unlike indexing, where by and large cost is the main consideration in comparing similar fund offerings, in factor-based investing it is an important variable, but only one variable.
Other considerations we encourage investors to look at when reviewing factor-based strategies include the depth of the manager’s research and experience in running these strategies. We also highlight the degree of factor diversification present in the strategy – i.e., is a given “smart-beta” fund basically just a single-factor portfolio such as a value fund with different marketing? – and the consistency of the manager’s approach – i.e., does the manager have flexibility to adjust his exposures? Are the risks of a given fund driven by factor exposures or by manager decisions?
One of the issues that has received a lot of attention is whether certain factors, such as the value factor, have been “overgrazed” and their historical advantage arbitraged away. Value has underperformed growth and the broader market over the last decade in the U.S. and internationally. How do you measure whether the factors you use are overgrazed? Will the performance of the value premium be lower going forward?
We have done some research on this – in value and small-cap investing in particular, it is possible to make a case that those premiums may have been lower over the last 20-30 years than they were prior to the 1980s, at least as it pertains to U.S. equities.
That said, we don’t base our strategies on any specific expected outperformance of any single factor – hence the multi- in multi-factor.
In theory, even if there were no value premium in the future but it simply moved differently than growth (outperforming one year, underperforming the next), we’d still advocate for a moderate exposure to value for the diversification benefit.
We also have yet to see evidence that the value premium will ever disappear completely – the fundamental principles of risk and return would suggest that stocks the market values more cheaply due to perceived risk should have a greater return.
Do you see the recent increased volatility as challenging, given your use of momentum?
The recent market volatility hasn’t been anywhere near enough to impact our strategies (at least not yet) – we’re actually having a quite positive 2018 YTD.
Also, as with value, momentum exposure in our strategy is carefully managed and only one of many factors. It’s important, but we recognize the potential downside to momentum (as we saw in 2008-2009).
A major focus of financial media seems to be the perceived “death of active management.” What has caused the flow of funds from active to passive management since the financial crisis? Do you believe active management is indeed on its way out?
Increased awareness of risk after the 2008-2009 crisis and more and easier access to information was inevitably going to put major pressure on many active managers – investors find is easier to compare costs, are more aware of the risk of underperformance, and large institutional-style investors have had another decade or more to evangelize about the benefits of passive / index style investing. Very broadly, we don’t view this as inherently bad.
Active management will probably always be with us, however – if every investor indexes, the market would (based on the EMH) become less efficient, as fewer investors would attempt to judge the relative worth of various investment options. This (in theory) would eventually lead to increased opportunities for active managers to add value.
What have you been telling investors about the recent market swoon? What guidance would you offer to advisors who are fielding questions from risk-averse clients?
If anything, the recent dips in February were small and overdue (relative to history). The small drawdowns and remarkably low volatility of 2017 were abnormal when you look at stock market history.
Investors would be well-served to take the current environment as an opportunity to review their risk exposures and to consider taking some gains earned since 2009 off the table – this depends on many variables, but we think it is a good thought process for all investors to follow, even if they decide to maintain their current aggressive exposures.