What is the best way to predict success?
In baseball, the game’s strategy was forever changed when Oakland Athletics traded in the standard scout’s intuition for a data-driven approach. It was a switch that eventually led the team to an impressive 20-game winning streak, depicted in the movie Moneyball—it also kickstarted a broader revolution in sports analytics.
Similarly, successful data patterns are also being discovered by experts in the investing world. One such framework is factor investing, where securities are chosen based on attributes that are commonly associated with higher risk-adjusted returns.
Factor Investing 101
Today’s infographic comes to us from Stoxx, and it explains how factor investing works, as well as how to apply the strategy in a portfolio.
A Selective Approach
There are two main types of factors. Macroeconomic factors, such as inflation, drive market-wide returns. Style factors, such as a company’s size, drive returns within asset classes.
Analysts have numerous theories as to why these factors have historically outperformed over long timeframes:
- Rewarded risk
Investors can potentially earn a higher return for taking on more risk.
- Behavioral bias
Investors can be prone to acting emotionally rather than rationally.
- Investor constraints
Investors may face constraints such as the inability to use leverage.
Astute investors can capitalize on these biases by targeting the individual factors driving returns.
The Common Style Factors
Based on academic research and historical performance, there are five style factors that are widely accepted.
- Size: Smaller companies have historically experienced higher returns than larger companies
- Low Risk: Stocks with low volatility tend to earn higher risk-adjusted returns than stocks that have higher volatility.
- Momentum: Stocks that have generated strong returns in the past tend to continue outperforming.
- Quality: Quality is identified by minimal debt, consistent earnings, steady asset growth, and good corporate governance.
- Value: Stocks that have a low price compared to their fundamental value may generate higher returns.
It is becoming more straightforward for investors to implement these factors in a portfolio.
How Can You Apply Factor Investing?
All investors are exposed to factors whether they are aware of it or not. For example, an investor who puts capital in an ESG fund—targeting companies with good corporate governance—will have some level of quality exposure.
However, there are various approaches investors can take to implement factors intentionally.
Factors perform differently over the course of a market cycle. For example, low volatility stocks have historically performed well during market downturns such as the 2008 financial crisis or the 2015 sell-off.
Investors can consider macroeconomic information and their own market views, and adjust their exposure to individual factors accordingly.
Factors tend to exhibit low or negative correlation with each other. For a long-term strategy, investors can combine multiple factors, which increases portfolio diversification and may provide more consistent returns.
For each factor, there are investments that lie on either end of the spectrum. Experienced, risk-tolerant investors can employ a long-short strategy to play both sides:
- Hold long positions in attractive securities, such as those with upward momentum
- Hold short positions in unattractive securities, such as those with downward momentum
This diversifies potential return sources, and reduces aggregate market exposure.
Capturing Factors Through Indexing
Active managers have been selecting securities based on factors for decades. To capture factors with precision, managers must carefully consider numerous elements of portfolio construction, such as the starting investment universe and the relative weight of securities.
More recently, investors can access factor investing through another method: indexing. An indexing approach provides a framework for capturing these factors, which helps simplify the investment process. Based on objective rules, index solutions provide a higher level of transparency than some active solutions.
Not only that, their efficiency makes them more suitable as tools for building targeted outcomes.
The Future of Factors
In light of indexing’s various benefits, it’s perhaps not surprising that exchange-traded factor products have seen immense growth in the last decade.
In addition, there’s still plenty of room for factor ETF expansion in equities and other asset classes. Only about 1% of factor ETFs invest in fixed income, and 70% of surveyed institutional investors believe factor investing can be extended to the asset class.
As solutions continue to evolve, factor products could become the foundation of many investors’ portfolios.
The Fed’s Balance Sheet: The Other Exponential Curve
Quantitative easing has led to an unprecedented expansion of the Fed’s balance sheet, leaving some economists with more questions than answers.
The Fed’s Balance Sheet: The Other Exponential Curve
As the threat of COVID-19 keeps millions of Americans locked down at home, businesses and financial markets are suffering.
For example, a survey of small-business owners found that 51% did not believe they could survive the pandemic for longer than three months. At the same time, the S&P 500 posted its worst first-quarter on record.
In response to this havoc, the U.S. Federal Reserve (the Fed) is taking unprecedented steps to try and stabilize the economy. This includes a return to quantitative easing (QE), a controversial policy which involves adding more money into the banking system. To help us understand the implications of these actions, today’s chart illustrates the swelling balance sheet of the Fed.
How Does Quantitative Easing Work?
Expansionary monetary policies are used by central banks to foster economic growth by increasing the money supply and lowering interest rates. These mechanisms will, in theory, stimulate business investment as well as consumer spending.
However, in the current low interest-rate environment, the effectiveness of such policies is diminished. When short-term rates are already so close to zero, reducing them further will have little impact. To overcome this dilemma in 2008, central banks began experimenting with the unconventional monetary policy of QE to inject new money into the system by purchasing massive quantities of longer-term assets such as Treasury bonds.
These purchases are intended to increase the money supply while decreasing the supply of the longer-term assets. In theory, this should put upward pressure on these assets’ prices (due to less supply) and decrease their yield (interest rates have an inverse relationship with bond prices).
Navigating Uncharted Waters
QE falls under intense scrutiny due to a lack of empirical evidence so far.
Japan, known for its willingness to try unconventional monetary policies, was the first to try QE. Used to combat deflation in the early 2000s, Japan’s QE program was relatively small in scale, and saw mediocre results.
Fast forward to today, and QE is quickly becoming a cornerstone of the Fed’s policy toolkit. Over a span of just 12 years, QE programs have led to a Fed balance sheet of over $6 trillion, leaving some people with more questions than answers.
This is a big experiment. It’s something that’s never been done before.
Kevin Logan, Chief Economist at HSBC
Critics of QE cite several dangers associated with “printing” trillions of dollars. Increasing the money supply can drive high inflation (though this has yet to be seen), while exceedingly low interest rates can encourage abnormal levels of consumer and business debt.
On the other hand, proponents will maintain that QE1 was successful in mitigating the fallout of the 2008 financial crisis. Some studies have also concluded that QE programs have reduced the 10-year yield in the U.S. by roughly 1.2 percentage points, thus serving their intended purpose.
Central banks … have little doubt that QE does operate in many ways like conventional monetary policy.
Joseph E. Gagnon, Senior Fellow at the Peterson Institute for International Economics
Regardless of which side one takes, it’s clear there’s much more to learn about QE, especially in times of economic stress.
The Other Exponential Curve
When conducting QE, the securities the Fed buys make their way onto its balance sheet. Below we’ll look at how the Fed’s balance sheet has grown cumulatively with each iteration of QE:
- QE1: $2.3 Trillion in Assets
The Fed’s first QE program ran from January 2009 to August 2010. The cornerstone of this program was the purchase of $1.25 trillion in mortgage-backed securities (MBS).
- QE2: $2.9 Trillion in Assets
The second QE program ran from November 2010 to June 2011, and included purchases of $600B in longer-term Treasury securities.
- Operation Twist (Maturity Extension Program)
To further decrease long-term rates, the Fed used the proceeds from its maturing short-term Treasury bills to purchase longer-term assets. These purchases, known as Operation Twist, did not expand the Fed’s balance sheet, and were concluded in December 2012.
- QE3: $4.5 Trillion in Assets
Beginning in September 2012, the Fed began purchasing MBS at a rate of $40B/month. In January 2013, this was supplemented with the purchase of long-term Treasury securities at a rate of $45B/month. Both programs were concluded in October 2014.
- Balance Sheet Normalization Program: $3.7 Trillion in Assets
The Fed began to wind-down its balance sheet in October 2017. Starting at an initial rate of $10B/month, the program called for a $10B/month increase every quarter, until a final reduction rate of $50B/month was reached.
- QE4: $6 Trillion and Counting
In October 2019, the Fed began purchasing Treasury bills at a rate of $60B/month to ease liquidity issues in overnight lending markets. While not officially a QE program, these purchases still affect the Fed’s balance sheet.
After the COVID-19 pandemic hit U.S. shores, however, the Fed pulled out all the stops. It cut its target interest rate to zero for the first time ever, injected $1.5 trillion into the economy (with more stimulus to come), and reduced the overnight reserve requirement to zero.
Despite receiving little attention in the media, this third measure may be the most significant. For protection against bank runs, U.S. banks have historically been required to hold 10% of their liabilities in cash reserves. Under QE4, this requirement no longer stands.
No End in Sight
Now that the Fed is undertaking its most aggressive QE program yet, it’s a tough guess as to when equilibrium will return, if ever.
After nearly two years of draw-downs, Fed assets fell by just $0.7 trillion—in a matter of weeks, however, this progress was completely retraced.
QE4 is showing that what goes up, may not necessarily come down.
Bridging the Gap: Wealth Isn’t Just for the Wealthy
The UK has a financial adviser gap, leaving about 51 million adults without advice. Learn how wealthtech makes investing accessible for everyone.
In the UK, money is the #1 cause of stress—ranking above physical health, work, or family.
When people begin investing, they see immediate emotional benefits compared to non-investors. In fact, investors are 16 percentage points happier, and 23 percentage points more positive about their well-being.
However, only 37% of Brits hold market-based investments. So why aren’t more people taking steps to invest? Today’s infographic from BlackRock outlines the barriers people face, and how wealthtech can help address these issues at scale.
The Wealth Problem
A variety of hurdles keep people from taking control of their finances.
- Lack of Resources: 59% of Brits feel they don’t have enough money to invest.
- Lack of Knowledge: 39% say a lack of knowledge holds them back.
- Fear of Failure: 34% are afraid of losing everything if they invest.
All of these factors culminate in insufficient investing. In fact, 50% of the €26 trillion European wealth market is currently in uninvested cash, earning zero interest.
What’s the Current Solution?
Traditionally, investment advisers helped tackle these issues. However, investors have faced challenges accessing professional advice in recent years.
A shortage of UK advisers is a main contributing factor:
- There are only 26,700 advisers, who can service an average of 100 clients each.
- This leaves over 51 million adults without professional advice.
Among available advisers, many impose investment minimums or fees that create barriers for lower-income populations. Financial advisers charge an average of £150/hour, and half of all surveyed advisers turned away clients with less than £50,000 to invest.
With so many hurdles to overcome, how can Brits take charge of their investments?
A Modern Solution
Wealth technology—or simply wealthtech—helps address these issues at scale, offering four main digital-first solutions:
- Helps investors build better portfolios.
Gone are the days of rudimentary spreadsheets. With the help of algorithms and machine learning, investors can now automatically build sophisticated portfolios.
- Helps advisors scale their services.
The automation of time-consuming processes allows advisers to service more clients.
- Reaches more people.
Wealthtech is accessible for all, not just the wealthy. For example, micro-investing apps allow investors to make small, regular contributions without paying a commission.
- Modernises infrastructure.
Wealthtech updates old legacy systems with more streamlined, automated systems. As a result, paper-based processes are replaced with mobile transactions that can be done with the click of a button.
These benefits can be applied across various branches of wealth management.
The Wealthtech Ecosystem
Investors can choose one of three main paths, based on their level of knowledge and interest.
“Do It Yourself” Investing
Confident investors who enjoy managing their own money can trade securities through self-directed online platforms.
“Do It For Me” Investing
Novice investors can use platforms that execute trades on their behalf, such as micro-investing or robo-advisers.
“Do It With Me” Investing
For investors in the middle of this spectrum, certain platforms offer a hybrid of digital transactions and professional advice.
With a wide variety of solutions available, investing has never been easier.
It’s clear Brits are open to the shift: 64% say new technology would help them be more involved in their investments.
As wealthtech evolves, it will be seamlessly integrated into daily life as part of a holistic financial services offering. Traditional barriers will be broken down, empowering individuals to take charge of their financial future.
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