What fund selectors look for in factor ETFs
This interview first appeared in the Q1 2021 edition of Beyond Beta
Hoshang Daroga, Director of Quantitative Investments at Copia Capital Management, addresses ETF flows Tom Eckett, Editor, on the rise of thematic ETFs, best practices for selecting factor ETFs and why his allocation to smart beta would increase if long-short strategies were launched.
Daroga joined Copia Capital in 2015 after leaving LSV Asset Management, where he was a quantitative research analyst for less than a year. Previously, he was an equity research analyst at MLV and a senior trader at TransMarket Group.
Are you using smart beta or factor products in your clients’ portfolios?
We use factor ETFs and their use depends a lot on the investment mandate. We have mainly used these products to increase diversification and move away from passive funds (monitoring the market capitalization index) or to adjust the overall risk exposure for a specific asset class.
How much of your wallets does Smart Beta typically make up?
The proportion of factor ETFs has historically varied between 0% and 10% and depends on the investment objective of the portfolio as well as on market conditions. We have been comfortable with the current level of use as well as the selection and do not seek to increase or decrease these exposures.
How do you see smart beta / factor ETFs?
We see these products as tools to diversify away from passive investments (followed by the market capitalization index), but also as an active investment based on rules. Being rules-based gives it predictability, which makes them ideal tools for expressing specific views and obtaining targeted exposures in a profitable manner.
What parts of the smart beta / factor spectrum (including thematic ETFs) are you most interested in right now?
For the preservation of wealth, we really like mandates to have strategic exposure to a minimum volatility factor. It has always shown that it has better risk characteristics compared to benchmarks.
My favorite for the alpha generation has always been the momentum. It may have short-term biased drawbacks, but in the long run I think the momentum will eventually outperform because it is a behavior anomaly.
When focusing on a particular smart beta product to invest in what factors do you take into account?
Once we have identified a factor that we would like to be exposed to, we follow our systematic selection process to identify any ETFs that could provide the required exposure. The filtering system looks for a number of parameters, such as assets under management, total expense ratio (TER), bid / ask spreads, domicile, replication methodology – we prefer physical replication, for example.
Along with smart beta and factor investing, we’ve also seen the rise of thematic ETFs – are you interested in that?
Thematic investing has gained much more interest in recent years compared to factor strategies. This is mainly due to the good performance of thematic strategies compared to factor products as well as the fact that thematic investing is much easier to understand.
We have used themes such as cybersecurity, healthcare innovation and clean energy in specific portfolios which have all delivered excellent returns over the past year. While the long-term outlook remains strong, we believe valuations are extremely tight and may ease on some of them.
Are you concerned about the recurring accusations of hacking and data mining at all levels and smart beta strategies? Are the identified bonuses really that robust?
Data mining is a serious problem and investors need to be very active.
Frankly, it has been very difficult to explain Smart Beta to our customers, but since our use is limited, it’s not something to be concerned about. Given the current environment, interest has been limited.
Are there specific areas where you would like to see new products emerge?
The biggest gap in my opinion is the lack of long-short strategies. Smart beta ETFs have usually only been around for a long time and if you look at performance, a lot of it comes from the beta exposure in the market.
Factors are basically long-short portfolios and it would be good to have products that do not carry market risk and are able to capture pure alpha from a factor. These can potentially act as absolute return strategies that would fit nicely into a multi-asset portfolio.
Are you interested in multifactor investing?
Multifactor products are great for investors who just want to add factor strategies to the composition of the portfolio, but we normally prefer single factor products. We view single-factor ETFs as precision tools for adjusting the overall factor exposure of the portfolio.
With single factor ETFs, we can target specific factors that a portfolio may be missing. Multifactor ETFs, on the other hand, tend to simply increase factor exposure for all factors, and in some cases, portfolios can find themselves overexposed to a specific factor by doubling it from elsewhere.
Therefore, our preference has been primarily for single factor products, as they tend to give us more control when building the portfolio versus a multi-factor strategy.
By 2025, do you think you’ll be making heavy use of smart beta products and factor ETFs?
We believe our use of thematic products could increase over the next few years, but factor strategies would be primarily driven by market conditions. Our adoption would increase if we saw more long-short type products on the market. careful when investing in such strategies.
Due diligence and research are essential to understanding how the index is constructed in order to ensure that the factor exposures are genuine and academically proven.
Having seen the world of quantitative hedge funds, data mining is a much bigger problem than ETFs that track indices from reputable index providers.
This article first appeared in the Q1 2021 edition of Beyond Beta, the world’s only factor investing publication. To receive a complete copy, Click here.