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Jason Hsu is one of the best-known names in smart beta investing, having played a major role in Research Affiliates’ development of its pioneering fundamental indexing approach back in 2005. After more than a decade at Research Affiliates, earlier this year he founded a new company, Rayliant Global Advisors, which provides smart beta and quantamental products in the Asian market. We spoke to Jason to find out his views on the state of factor investing today and what prompted his business move to Asia.
“Ten years ago factor investing was seen as something very quanty, very niche, and very hard to market. This was partly because it used language and images that were unfamiliar to, and didn’t resonate with, investors. But with the advent of the smart beta label – in what was essentially a rebranding exercise – factor investing has moved to the mainstream.”
“Overall, factor investing has become much more accessible. And I think more importantly, it’s become much cheaper. Marketing, rebranding, and education have increased awareness of factor investing, but I think the lower costs that have come with the greater availability of factor products have provided the greatest benefit to end-investors, directly leading to better ultimate investment outcomes.”
“Yes – like all strategies, when there’s too much flow, there’s always an impact on forward-looking return. But smart beta is a very broad term that encompasses several different factors and a vast number of products that provide access to them. And these factors wax and wane in terms of popularity and flows.”
“In recent times, low-volatility and quality-oriented strategies have attracted most of the flows, so from the valuation perspective these factors currently look more expensive, both in historical terms and also relative to value strategies. So I wouldn’t say that all smart beta has become expensive. Rather, most smart beta price increases have been limited to those popular areas that have performed well and received performance-chasing inflows. It’s important for investors to be aware that whenever a theme – factor-based or otherwise – becomes popular, its forward-looking return generally falls.”
“That was my suspicion, so I researched this with two other professors. We looked initially at value, because value is one of the oldest and best-known factors, and then considered other factors. We wanted to understand how something so well-known and easy to implement can persist, so we tested how much arbitrage profit has been generated. We sought to conclude whether profit has been arbitraged, say, half or completely away.”
“Arbitrage would mean the premium moves closer and closer to zero. What we found, somewhat surprisingly, was that we were not really seeing arbitrage, but something cyclical. The premium would fall for a period of time, even turning negative, but would then become positive again. What appeared to be the driver was flows in and out of factors. Large flows went into value if it had been successful recently, pushing premiums below zero if too many flows went in, as was the case in 2006-07. But once the premium became negative there were massive outflows, and before you knew it there was a positive premium once again and the cycle continued. So it’s more to do with trend-chasing than arbitrage capital.”
“All the evidence suggests that on average, people who try to play factors by trend-chasing in a naïve way lose money. This means the premium is fairly safe from arbitrage capital if there’s a lot of naïve capital pushing prices around rather than arbitraging away the effect.”
“Flows are quite hard to see, so generally if you want to time factors you’ll do it by looking at very recent price performance and essentially betting on factor mean reversion. To be honest, all predictive signals in finance are weak, so it’s a bit like playing blackjack: If you count cards well, your edge is maybe 1%, so you shouldn’t bet a lot on any single hand. What you need to do to maximize your chance of success is to play many, many hands, over a lot of tables, over a very long night.”
‘Timing factors aggressively is a dangerous proposition’
“But you can’t do that with factors because there aren’t many factors to choose from, so you’re limited in terms of how many hands you can play simultaneously. What’s more, the mean reversion period we see is probably over a 3-5-year cycle, which means you don’t get to play many hands over time. So while using predictive regressions to time factors might give you a slight edge, timing factors aggressively is a dangerous proposition.”
“In the past, the conversation around quality factors has been very confusing and there have been several different definitions, many of which don’t have sound theoretical underpinnings. I like how the new model resolves some of this confusion.”
“Looking at profitability and investments together, as the new model does, can give you a very differentiated view of a company. If you think about traditional MBA textbook teaching, firms make capital budgeting or investment decisions based on the return on equity of a project and their cost of capital, so if they have lots of good projects they’ll make slightly more investments.”
“If you want a test of corporate prudence, and want to avoid companies that overinvest because their managers are overconfident in their own ability or simply like to empire-build, then beware firms with low ROE and very high investment – that would be a huge red flag. But if a firm has strong profitability as a result of multiple high-ROE projects and a relatively conservative level of investment compared to its industry peers, that’s suggestive of more disciplined, prudent corporate management.”
“We’ve seen in the financial literature that both these characteristics are under-valued by investors, so there’s strong potential for them to be successful. And I think both the new factors are clean, easy to understand, and correlate well with what’s already in the literature, so I like them much more than many other definitions of quality.”
“Bill Sharpe, one of the originators of the capital asset pricing model, has often asked me: If fundamental indexing or value investing really works, who’s the dummy on the other side of the trade? That’s a great question – any manager who thinks he has an edge over the market must know who’s supplying them with the alpha and why they’re willing to do so. As we look at more data, what we’ve come to realize is that, generally, it’s a result of persistent behavioral biases and mistakes made by more naïve investors – the dummies certainly aren’t the other asset managers or prop desk traders.”
“So it makes sense to go to markets where there is very high retail speculation rather than those where assets are mainly delegated to professional managers. Retail participation can be as high as 80–90% in Asia, so that suggests it’s a place where a disciplined manager could have a persistent edge. There are also relatively few institutional-quality managers in the region, so it’s a great opportunity for someone who has that background to disrupt the ecosystem.”
“It’s early days at the moment, but we have seen very strong interest. There’s definitely a craving for high-quality institutional managers, and there’s a fascination about our model-based, systematic, research-oriented approach. We expect what we’re providing to have great resonance with investors in the Asian market.”