Bringing the human factor to index investing

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by Chandra Seethamraju, director of systematic modeling at Franklin Templeton Solutions

The skills and insight human oversight brings should play a crucial role in the index investment process. The emergence of risk-factor investing and the evolution of traditional indexes have opened up fresh opportunities to bring a human touch to what has traditionally been considered the passive exchange-traded fund space. Chandra Seethamraju, director of systematic modeling at Franklin Templeton Solutions, details what he sees as a ‘smart’ approach to investing in these vehicles.

It was Austrian neurologist and psychiatrist Viktor Emil Frankl who said, “A human being is a deciding being.” But in many aspects of our modern lives, it seems human beings are handing over decision-making to computers. Recommendations we encounter when shopping online. Suggestions for music on streaming sites. Potential matches on dating apps. All of these are all built on algorithms.

Read more: The ABCs of smart investing

While it might seem we are simply outsourcing decision-making to a computer, in each case we are relying on technology to serve us within certain parameters that human beings have set. At the heart of each example is a human decision maker who has constructed the framework in which the algorithm operates. The more skilled and intuitive the human designer, the better the potential outcome for the human user.

Enter smart beta

Smart beta portfolios range from fairly straightforward to quite complex. One of the simplest approaches holds securities in equal weights, rather than weighting them by market capitalisation (market cap).

Meanwhile, a quantitative approach systematically analyses, selects, weights and rebalances portfolio holdings based on certain investment style characteristics known as factors. Some focus on a single factor and others combine more than one factor into a single portfolio.

Traditional market-capitalisation-weighted indexes are known to contain certain biases. They are, by their nature, backward-looking. Rather than honing in on stocks with potential opportunity, they reflect stocks that have performed well in the past (mega-cap stocks), stocks that have traded at high multiples or that belong to popular industries. Conversely, active management strives to identify potential and apply it.

Index investing has been going through an evolution in recent years, particularly with the emergence of advanced approaches to index construction. One of these is known as smart beta.

Put simply, traditional market-capitalisation indexes reflect a hands-off approach. They follow a simple, generally market-capitalisation-based index. Meanwhile, smart beta employs criteria (or factors) other than market cap.

Approaches range from relatively simple to more complex. Exchange-traded funds (ETF) are then designed to track these custom indexes.

The factor: a DNA marker

A factor is a primary characteristic of an investment that explains a stock’s behaviour over long periods of time. One can think of a factor as a DNA marker of an investment that causes it to respond to certain events. It drives the investment to behave the way it does over time. Stocks can be grouped based on the primary factors they share. Some factors have provided investors with positive returns above and beyond market indexes over the long term, called a ‘return premium’.

Factors that have provided a return premium over time include:
•Quality – companies with stable earnings growth.
•Value – stocks that are attractively priced relative to historical and forecasted valuations, and historically have paid attractive dividends.
•Momentum – companies that have demonstrated strong performance over the past six-to-12 months.
•Volatility – stocks that have demonstrated lower-than-average variability of returns.

There have been plenty of investment fads come and go over the years. There are certainly some commentators who believe smart beta is just another one of those fads.

But the smart beta ETF can bee seen as an advancement in the binary world of passive and active management. Advancements in index construction and portfolio design represent an opportunity for investors with the right tools and expertise to potentially improve risk-adjusted investment performance over time. This is something many investors would likely find attractive.

There is an opportunity to apply further enhancements to smart beta. This involves bringing the research skills, experience and insight honed in an active management sphere to the strategic construction of sophisticated indexes.

Market-cap-based indexes have served a useful purpose as indicators of broad market performance and as benchmarks against which to measure active manager performance. Rules-based index design that analyses individual stock exposure to specific factors provides a more advanced, forward-looking – and more nuanced – approach to targeting specific market outcomes.

Even an index determined by market weights is exposed to factors such as quality, value, volatility and momentum. For index funds, these exposures are determined by the stock market’s ups and downs on which market-cap indexes are based.

For most investors, particularly those seeking an outcome other than market exposure, it’s preferable to plan for factor exposure, rather than be subjected to it by market fluctuations. A systematic factor approach offers the advantage of always knowing exactly which factors are driving your index’s returns.

Such an approach combines the appeal and intuition of more sophisticated passive approaches – transparency, diversification, a rules-based methodology and lower costs – with the prudence and perspective of an active manager who uses research to determine specific exposures that pursue a desired outcome. That’s why an index designed and constructed on risk factors should not neglect the most important factor of all: the human factor.