Morningstar Advisor - October/November 2012 - (Page 42)

Spotlight Factor Strategies Gain Footholds in Practices By Michael Brennan Proponents say that education and openness are keys to keeping clients believing in system. Wind back the clock about five years. Replay the drumbeats to which the respective proponents of active asset management and passive investing marched. You have the staid option—the one that can’t deliver the moonshot. You have the higher-upside option— the one that can erase years of returns with one ruinous quarter. The risks and rewards on both sides were relatively easy to understand. The two-sided debate seems antiquated now in a world where global financial turmoil has undercut the stability previously thought to be a central value proposition to traditional passive asset management and where nothing has happened to change the notion that active management can be an extremely risky home for one’s nest egg. This environment has contributed to the increased interest practitioners are seeing in factor-based investing, an approach that applies tenets of both active and passive investing strategies. “Ten years ago, only the nerdiest folks were into this story (factor investing),” says Matt Hall, co-founder of Hill Investment Group in St. Louis. “The collapse in 2008, that experience shook a lot of people. It was the first time that many investors started wondering if they had the right manager, the right approach.” Hall views his job, as well as that of his peers in the financial community tasked with convincing investors and advisors of the merits of a factor-based approach, is to move the conversation away from traditional assetallocation concepts. (Hall created a partnership with Bridgeway Capital Management, the quantitative investment management firm led by John Montgomery. Hall founded LongView Partners to distribute Bridgeway’s strategies to advisors.) Factor investors focus more on the characteristics that they believe drive returns, such as size and price. Hall says that the approach aims to minimize correlation and lower beta while boosting returns. “You want that exposure to small caps and value for one very simple reason: These are the areas where you’ve been paid a premium,” Hall says. “People want some return over what a pure market exposure would give you. But it’s considered nerdy because all the support comes from academia.” (In this issue’s Morningstar Conversation on Page 50, Cliff Asness of AQR Capital Management and Rob Arnott of Research Affiliates, both quant pioneers, discuss whether a size premium actually exists.) Instituting a Factor-Based Approach Financial Services (which includes Buckingham Asset Management and BAM Advisory Services). Buckingham sticks with passively managed investments with a focus on factor-based options, and from the day new clients walk through the door, Masek coaches them to make sure they know what they’re getting into. “With an active approach, it’s a lot harder to control your exposure to the risk factors,” says Masek, who has a Ph.D. in mathematics from UCLA. “Say you want to capture exposure to the small-cap risk. If you have an active manager with discretion to go elsewhere, you don’t really have consistent exposure to that risk factor. It’s a different philosophy, a different approach. Essentially, it’s hard to serve two masters at the same time. Are you trying to get exposure to the risk factors or to a manager’s stock-picking talents? You can do both, but not at the same time.” Masek says that Buckingham has been able to limit client turnover to around 2% annually—including during the 2008 downturn—because of the organization’s emphasis on communications and education. In addition to explaining exactly what a factor-based approach will look like in different market environments, Buckingham’s advisors assemble for each client a unique portfolio based on considerations such as Vladimir Masek advises clients at another St. Louis-based firm, the Buckingham Family of 42 Morningstar Advisor October/November 2012

Table of Contents for the Digital Edition of Morningstar Advisor - October/November 2012

Morningstar Advisor - October/November 2012
Letter From the Editor
Ill Communication
Do You Use Factor-Investing Strategies?
Practicing What She Preaches
How to Determine the True Price of ETFs
The Quant Factor
Managers Dispute the Death of Equities
Investments á la Carte
Investment Briefs
Five Inconvenient Truths of Manager Research
Health Care’s Outlook Clarifies
Exploring the World of Factors
Uncloaking the Alpha Machine
Factor Strategies Gain Footholds in Practices
Big Mo
Fitting Factors Into the Formula
Clients Have a Friend in Luther King
Less-Liquid Holdings Mean More-Solid Results
Retirement-Withdrawal Strategies Quantified
Amid Turmoil, Don’t Discount Foreign Equities
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Should I Stay or Should I Go?

Morningstar Advisor - October/November 2012