Employing Factors in a Portfolio’s Core
Written by: Larry Whistler, Chief Investment Officer, Nottingham Advisors
When employing core/satellite investment strategies, investors often focus only on low-cost market cap-weighted indices when constructing the core, or strategic, allocation of the portfolio in order not to stray too far from an established benchmark. A willingness to explore non-cap weighted indices, or strategic beta, can often prove valuable in establishing a less volatile, more consistent return profile in the heart of the portfolio.
So-called “strategic-beta” exchange-traded funds (ETF’s) can be loosely defined as any ETF that doesn’t track a market-cap weighted benchmark. Typically, the ETF’s are built around some factor – value, quality, momentum, size or low volatility – or some combination of factors. These ETF’s typically follow a rules-based process for security selection, and often will exhibit very different return profiles than standard market-cap weighted indices.
At the heart of strategic-beta is an adherence to a factor, or combination of factors, with security selection designed to focus on those companies, or groups of companies that best exhibit this specific trait. For example, low-volatility, or minimum-variance portfolio ETF’s, have exhibited unique return profiles over time versus standard market-cap weighted indices, capturing roughly 85-90% of the cap-weighted indices’ upside, and only 70-75% of the downside. This can be a very helpful return profile for conservative investors worried about the risk of loss in their portfolio.
Alas, as with most things in investing, there is no free lunch. Factor outperformance, or alpha, is not assured over shorter periods of time, although academic studies dating back to the well-known Fama-French 3 factor model paper in 1993, have validated the existence of a return premium over market cycles. At Nottingham Advisors, we prefer to “hedge our bets” by including a multi-factor ETF with a single-factor ETF (our bias is towards minimum-variance ETFs), in order to help smooth out the return profile during periods of single-factor underperformance.
An analysis of single & multi-factor return profiles, in conjunction with market-cap weighted exposures, shows varying return profiles over time. In some, volatility is accentuated, while in others it’s diminished. Oftentimes, exposure to the momentum factor can lead to sustained periods of outperformance in up-cycles, and below-average returns during bear markets. Beauty tends to be held in the eye of the beholder.
An example of a blended core is illustrated below, with return data generated from the past five years. The “Factor-based core” includes a single-factor ETF, a multi-factor ETF and a straightforward low-cost market cap-weighted ETF, in equal weights. The “Cap-weighted Core” consists only of the straightforward, low-cost market cap-weighted ETF. As can be seen in the data table below sourced from Morningstar, the Factor-based Core realized greater return per unit of risk, as measured by the Sharpe Ratio (1.42 vs. 1.27) while generating positive alpha over this time period.
As suggested above, strategic-beta ETFs can be used as risk-mitigation tools as well as return-enhancing vehicles. Risk-management ETF’s typically center on low or minimum variance, low or high beta and risk-weighting schemes. Return enhancing ETF’s often employ equal-weighting or revenue-weighting schemes, fundamentally-weighted strategies, value, quality, size, growth or multi-factor approaches. Diligence is required as these vehicles run the gamut from “cheap and effective” to “expensive and useless”. Again, a thorough understanding of what it is you’re trying to accomplish is paramount.
Nottingham sees various strengths and weaknesses in market cap-weighted portfolios. On the plus side, they often provide the cheapest exposure to the broad market and can be highly liquid. To their detriment, it’s in the very nature of a cap-weighted index that an overvalued company can become a greater share of the index at the expense of the cheaper (and thus potentially more attractive) companies in the index.
As we make our way through year 8 of the current bull market, thoughts may be shifting away from return enhancement strategies to risk management schemes. Factor-based ETF’s, or strategic beta, can play an important role in helping protect gains earned over the past decade.
Learn more about Nottingham Advisors here.
Nottingham Advisors, LLC ("Nottingham") is an SEC registered investment adviser located in Amherst, New York. Nottingham and its representatives are in compliance with the current registration and notice filing requirements imposed upon SEC registered investment advisers by those states in which Nottingham maintains clients. Nottingham may only transact business in those states in which it is registered, notice filed, or qualifies for an exemption or exclusion from registration or notice filing requirements.
NBA Player Carl Landry Demonstrates the Value of Persistence in Life and Work
Written by: Jon Sabes
When you meet Carl Landry, stand-out college basketball player and nine-year NBA player, you imagine that becoming a professional basketball star was a straight forward run for the 6-foot-nine-inch power forward.
However, when you go deeper into Carl’s background, becoming a NBA professional was less than certain and little came easily to the 33-year-old from Milwaukee:
- He was cut from his high school team as a freshman and averaged less than ten points a game when he did play as a senior.
- He started his college career not at Purdue, but a junior college where it was not clear he would play.
- When he finally got to Purdue, he tore his ACL in his knee his first year and reinjured it the next year.
- While his family held a party for him the night of the NBA draft, he slept in the Philadelphia airport after missing a flight following a workout for the 76ers.
- In the NBA playoffs, Carl had a tooth knocked out, but came back in the same game to make a game-winning blocked shot as the Rockets beat the Utah Jazz 94-92.
Landry, who I interviewed on my podcast, Innovating Life with Jon Sabes (www.jonsabes.com), is a remarkable example of the value of “persistence.” In a time where technology creates the image that anything is possible at the touch of a button, persistence is an under-appreciated trait. When I spoke with Carl, I clearly saw someone for whom success has only come through a force of will that made him a NBA player, but it also made him a better player every year he played. That’s the kind of personality that has produced greatness in business as well as sports.
Carl was, in fact, drafted that night he spent in the airport. The Seattle Supersonics chose him as the 31st overall pick and then traded him to the Houston Rockets where he rode the bench for much of the first half of the season. When All-Star teammate Yao Ming was injured, he stepped in and played a key role in the Rockets astonishing 22-game winning streak (the third longest streak in NBA history). And, that season, after sitting on the bench for 33 of the first 36 games, he was named to the All-Rookie second team.
Carl was the first in his family to go to college. “I told myself that this was my ticket out, so I did everything I possibly could to be the best person in school and also on the court,” he said.
His family life in Milwaukee showed him what he didn’t want to do. “Just being honest with you, seeing some my cousins, peers, they went to work for jobs paying six, seven dollars an hour or they didn’t go to work at all and then living off welfare. I didn’t want that.”
When he was first injured, he had to contemplate the end of a career before it even got started. “When you have an ACL tear, it’s over…no more basketball,” he told me. “I said, God, give me health again and I’ll do everything I can to leave it all out on the line and be a successful individual.”
On my podcast, Carl pointed out another interesting lesson he learned in the NBA: Not doing things just to fit in.
“Fitting in was easy,” he said. “Doing everything that everybody else does was easy. If I stood out in some type of way, I’m going to have different results. I’m going to have stand-out results.”
That’s called the “Law of Contrast” and it produces that exact effect of changing the outcomes that everyone else is experiencing. Carl is smart, he recognized that differences make a difference, and doing whatever it takes is what is required to make real, meaningful differences.
Every off-season for the last 11 years, he has run a camp for kids in Milwaukee where he tells youth his story of hard work and persistence. “I always tell the kids to apply themselves and always be persistent,” he said. “If you dream, apply yourself and be persistent. With hard work, man, the sky’s the limit.”
When Carl says the sky’s the limit he means it. He is smart to recognize that it’s important to dream big, because if we don’t – we may be selling ourselves short. “You have to dream bigger than your mind could ever imagine,” he said. “I wanted a nice house. I wanted a nice car. I said, and I got all of that. So, what do I do, do I stop now? Maybe I didn’t dream big enough.” That’s a big statement coming from a kid who grew up to be the first in his family to graduate college and go on to be not only a top NBA basketball start, but a good businessman, father and someone who gives back to the community.
I’m convinced that in whatever he takes on as a basketball player or in his post-hoops career, Carl Landry is not going to stop getting better at whatever he does, and in the process of doing so, make the world a better place.
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