Since William Sharpe devised the single-factor model on which to base stock selection in 1963, factor-based investing has evolved to include more than 400 individual elements which may influence asset pricing.
This ‘factor zoo’, according to Eduardo Repetto, CIO at Avantis Investors, is obfuscating the real elements that should drive stock selection and is ultimately leading to under-performance.
“We have a factor zoo and the problem when you have so many factors, is how to put them together. There needs to be a comprehensive way optimise these factors when you’re analysing where to invest.”
Repetto argues that the proliferation of factors has distracted managers from looking at key company fundamentals and using those to inform stock selection.
Specifically, he looks for companies with high profitability with high book to market ratio since they enjoy an elevated discount rate making them good value.
“For example, when we think about price to book, we know that price is part of a valuation and it’s a proxy for the equity of the company. But no one is going buy a company by just looking at book value. You want to know something about the flows of the company and its earnings. You have to consider all these different variables which will impact market return and put that into a valuation framework.”
Repetto calls this the ‘systemisation’ of asset management which allowing managers to apply factors that truly impact likely market returns, while cutting out the noise of more ‘irrelevant’ influences.
“Too often we see that the security selection uses proxies that are not based on discount rates but on variables that are not linked to expected returns, so if investors are looking for returns, this becomes a problem.”
He adds: “Instead of having a zoo of factors or incomplete single-factor models that don’t look at a company holistically, let’s use all the teaching from factor investing and asset pricing modelling to evaluate and analyse companies. Post-factor investing is about finding companies with big discount rates with high expected returns that can add value to portfolios.”
Repetto argues that systematic approach is not based on “the cutting edge of financial science” but is rather the next evolution of factor investing.
And since post-factor investing is based on systems and data that already exist, managers can analyse thousands of companies cheaply and efficiently.
Looking at Avantis’ US funds, Repetto says fees sit at 15 basis points for the large cap value and fixed income funds, rising to 25 basis points for small cap value strategy which he says is outperforming the Russell Value Benchmark by between 6 and 7 per cent a year.
Repetto says: “What is interesting if look at our small cap value strategy we are analysing 700 names, and with so many stocks people assume our performance must be very similar to the benchmark. But we have an active share relative to the benchmark of 65 per cent. Our securities are different, the timing of our rebalancing is different, and the weightings are different. You can provide value if you are able to select the securities right, weight them right and rebalance them right.”
