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Can Your Factor Fund Deliver True Alpha?

Ben Johnson, CFA

Ben Johnson: Hi, I'm Ben Johnson, director of global ETF research with Morningstar. I'm here on the sidelines of the 2017 Morningstar Investment Conference, and I'm excited to be joined by Patrick O'Shaughnessy. Patrick is a principal and portfolio manager with O'Shaughnessy Asset Management. 

Patrick and I just finished discussing the concept of strategic beta, new approaches to factor investing, and what investors should be on the lookout for when it comes to selecting these funds. 

Patrick, thanks for joining me.

Patrick O'Shaughnessy: Thanks for having me, Ben.

Johnson: So, this concept of factor investing and generating alpha through trying to harness different factors, different risk premias is a new concept to many, and one of the chief sort of red flags that you've raised historically is that not all the products, not all the funds that set out to exploit these factors are created equal. Some are designed to generate true alpha; some are designed more for sort of asset gathering and scale. So, what's important to note about the difference between those two?

O'Shaughnessy: Well, the world of factors has gotten so popular. And, as always is the case on Wall Street, when something gets popular, the Wall Street complex creates a ton of product to satisfy that demand. The problem is, and you mentioned this idea of "alpha or assets." I think that's a perfect question to ask yourself when evaluating one of these ETFs or mutual funds.

What was the motivation behind it? Was the person that designed this doing it because they want to get the best risk-adjusted return? Or do they want something that they can raise a lot of money in and charge management fees for? And I think, unfortunately, and this is always the case on Wall Street, more of the motivation is that second camp, that gathering of assets.

So, our contention is that if you're going to be doing something in the world of factors, you need to focus on a more pure expression of those ideas. So, take value, for example. Value works because it's painful. These broad market tilts toward value, they're not painful. The largest holding is Exxon, right? Exxon doesn't look particularly cheap. It's not really a value stock. But it's the biggest holding in a lot of value ETFs. We think you need to focus on motivation being a pure expression of the factors that can deliver real alpha over time.

Johnson: So, you talked a lot about value, and I think there's little disagreement that value is one of sort of the twin pillars of the factor world, the other being momentum. What are some other factors that are out there that you've looked at that might be less well-known, and how do you think about building those?

O'Shaughnessy: So, there's one called shareholder yield that is a perfect example of this alpha/assets dynamic. So, shareholder yield is a simple formulation. It's a company's dividend yield, let's say it's 2%, plus the amount of shares it's repurchased in percentage terms in the last year. Let's say it's 7%. That would be a really high number. You add those two together; you get nine, a shareholder yield of nine.

Buybacks have become really popular, and a lot of the press has been very critical of buybacks because they think firms should not be buying back stock, but reinvesting in their own businesses. So, we would say in a whole, if you're doing a diluted approach like the asset gathering version, you would buy buybacks, broadly speaking. That hasn't worked. This idea has been high-conviction buybacks.

So, companies that are buying back, say, 5, 7, 10% of their shares. That's a ton in a short-term period. Those companies have done really well versus the broad market, so, very high shareholder yield, but it's a scarce group. You have to have a more concentrated portfolio to take advantage of that factor.

So, there's one idea in addition to value and momentum that we believe in because of the data, because of the historical record, where it's a good example of having to focus on a subset, not a broad market exposure.

Johnson: And during our conversation we talked about not only the data, but trying to understand the economic intuition behind what drives these factors. There's clear intuition, be it from a risk perspective, a behavioral perspective that underpins something like value, like momentum. What is the intuition, from an economic point of view, that drives shareholder yield as a potential way to isolate stocks that will generate excess returns?

O'Shaughnessy: Well, to be clear, it is a version of a value factor. When you look at these companies, they tend to also be value companies, so a lot of the same behavioral and risk-based reasons apply. I think that people do a very, markets in general do a very bad job of extrapolating. They take recent conditions and assume they're going to happen forever. These companies tend to be lower growth, more mature, less exciting, and very disciplined about their capital allocation. And that discipline is underappreciated by the market.

The fact that they return excess cash to shareholders to the degree that they do and tend to time those buybacks at very cheap prices, it's just a rare group, and markets have underappreciated that, I think for all the same reasons that they tend to underappreciate value stocks. It just leads to a different portfolio and a bit of a different return stream, which is why we like it as a complement to value and momentum.

Johnson: Well, Patrick, I want to thank you again for being here with us today. It's a great conversation, and we appreciate your insights.

O'Shaughnessy: Yeah. It's been fun as always, Ben. Thanks for having me.

Johnson: Thanks. For Morningstar, I'm Ben Johnson.