Join David Belinkie, CFP® at Spaugh Dameron Tenny, LLC as he interviews Managing Director at Symmetry Partners, Dana D'Auria about Factor Investing.
Transcript:
DAVID BELINKIE: Hello. I'm David Belinkie, a financial planner here at Spaugh Dameron Tenny. Joining me today is Dana D'Auria, managing director at Symmetry, a firm we partner closely with.
DANA D'AURIA: Thank you for having me, David.
DAVID BELINKIE: Welcome. Okay. So, Dana, can you give us an explanation of what factor in investing is?
DANA D'AURIA: Sure. So factor investing in the form that we practice is basically an academic approach to investing. You look at decades of financial research, and what these academics have tried to do is look for variables that explain the outperformance of certain stocks or groups of stocks. Right.
So everybody wants to know what stock is going to outperform. Are there any patterns that we observe over long periods of time in the data that can help us figure that out? And factors are these variables that have been identified by these academics as having some sort of explanatory power over the dispersion that we observe in stock returns, the way that certain stocks tend to outperform other stocks over the long haul. And so factor investing is about trying to take those insights from the academics and financial science and put them to practice in our portfolios.
DAVID BELINKIE: That makes sense. And how are these factors determined?
DANA D'AURIA: So when the academics are looking for factors, they're basically taking reams and reams of market research and testing various different possible metrics. So the original factor is, if you will, were the market, for example, factors that made sense that they would explain outperformance like how well your stock or your group of stocks correlates with GDP or interest rates or what have you. But what we found over time is that style factors such as, for example, low price or recent outperformance, these types of factors have tended to work better in the empirical research.
Meaning when you actually look at the data and you try different metrics and you say what does seem to explain stock returns? So they're determined usually by high-level academics working in top-tier journals, publish a big study and say, hey, we think we found something that works. Then other academics come in and kind of attack it, if you will, right?
This is the academic way, you know, and say, okay, well, can we prove or disprove? So the best factors are something that have been determined to work in and out of sample, meaning the first test, it works. Then you have another test in a different sample set overseas. Maybe, you know, the first one might have been U.S. and then you try it internationally. Does it work? And they also tend to be determined if they have a good economic explanation.
So you can you know, there's a saying if you torture the data long enough, it'll tell you whatever you want to know. So factors, you have to be careful that you're not finding some artificial spurious pattern that doesn't really have anything to do with explaining outperformance. So academics and practitioners like us that use their research try to apply a lot of hurdles to say that this is a real thing.
DAVID BELINKIE: So what does all of that actually mean for an investor?
DANA D'AURIA: For investors, it's really about trying to leverage this, right? It's about taking a disciplined approach to your investing. You can you know, there's sort of a spectrum you can kind of do complete market cap weighted, which means you say, I'm not going to try to outperform the market at all. I'm just going to accept whatever the market can bear. And then on the other side is traditional active management, where you hire somebody to try to pick the right stocks for you.
Factor investing is a way for the average investor to take a disciplined approach to the capital markets and say, I want to leverage what academics have taught us about how to outperform, but I want to do it in a very systematic way. I want to get rid of the emotion from investing if you will, and just base things on a systematic kind of codified approach, if you will. And so factor investing is really about doing that for the investor.
DAVID BELINKIE: Okay. It makes sense. And how can our partnership help us in achieving our goals of providing diversified investments to our clients?
DANA D'AURIA: So I think that when you talk about factor investing, you can be as diversified as much or as little as you want, right? You can look at factor investing from the standpoint that you're going to concentrate in certain stocks that really exhibit these factors. Or you can do what we do, which is we try to diversify across stocks. And you're really looking for groups of these different types of groups of stocks that exhibit these factors.
So when we put together an investment, we're really looking to diversify across all the stocks and then just overweight the ones that exhibit these factors as opposed to concentrating in the ones that have the highest factor either. It's not to say one way or the other is right or wrong, but there's volatility involved with this. Any one of these factors can fail to work for a long period of time. That's why they work. You know, that's probably why we get paid in the long run for taking the risk. To begin with, just like equity markets in general. So being very concentrated, you've really got to be ready for a rough ride and to ride it out a long time.
DAVID BELINKIE: So, Dana, I guess a question that I have is all this information is out there for people to know and to understand these factors. So how do you feel confident that not enough people have picked up on this and now those factors will no longer outperform?
DANA D'AURIA: It's a very valid concern. And if you look at the literature, there are literally hundreds of quote-unquote factors now. And what the studies suggested that a lot of those factors do get just completely arbitrage away. In fact, there are studies that tell you that it's not even you don't even have to wait until it's published.
Just the process of a paper circulating in the academic community, the word gets out and a lot of these factors go away. So when you're investing in factors, it's important that you're going after the factors that have kind of stood the test of time. You know, they're known. They've been known. And the factors that we're talking about are right there. They've been known for decades. And yet the performance continues to seem to persist.
And that suggests it doesn't say deterministically, but it does suggest that there are some phenomena in the market, probably a risk and or a behavior that is not going to be arbitrage two-way because it's kind of driven by something. For example, if it's a risk, let's say buying low-priced stocks is the risk that those stocks are or those firms are less able to weather storms. Right.
So that would be one reason that no matter how much, you know, a lot of people maybe just don't want to take that risk. They don't want to, in bad times, go with a bunch of stocks that have a little bit more trouble weathering the storm. Right. Or if it's behavioral, it just maybe, so for example, there's the thought that momentum as a factor exists because people become anchored to their beliefs.
And as long as we as a society can't conquer these biases and there's a lot of evidence that we are very unable as a group to conquer it, then the factor can and will persist. So there's a balance and there's no way to know for sure. And one of the things when you're building factor portfolios, you're always kind of watching, is there evidence that the factor is kind of dissipating? But in general, it's still certainly possible to invest in factors and expect and expect a premium over time.
DAVID BELINKIE: So, Dana, I guess the key question is then in a period of underperformance, how do you stay committed to the process?
DANA D'AURIA: Sure, it's a good question. And like any strategy, it's hard to judge by one period of underperformance. Certainly, factor investing is based on a long historical record. I think one thing is making sure you're diversified among the factors because the history suggests that it takes any one factor can underperform for longer than usually a blend of factors as well. But at the same time, it's really about recognizing that that's kind of par for the course.
The reason that you have the potential for the outperformance is in fact probably in part because you can go through these long periods of underperformance. And I would say that it's useful to remember that equity markets in general exhibit periods of underperformance. So when we think of investing in stocks versus investing in, you know, T-bills, I think most people would think like, well, yeah, of course I'll do better in stocks.
But there have been long periods, you know, ten plus year periods where stocks don't outperform T-bills even. Right. It's just the nature of the beast and it's the risk that you're taking and the reward you're getting is probably a direct result of that risk that you're taking. So we would say that the promise of getting in and out of the market at exactly the right time, picking the exact right stocks, that's just you know, a lot of research suggests that that's really unlikely.
So you either take the view that you're just going to take kind of the market so you don't have to feel the aggravation of being different from the market. But of course, the market can be down to where you say, I'm going to leverage this research. I'm going to understand that there's going to be periods of underperformance. But in the long run, I've got a higher potential for outperformance according to the evidence that we have.
DAVID BELINKIE: That makes perfect sense. Thank you so much for your time.
DANA D'AURIA: My pleasure. Thanks for having me.
