Every so often, when reviewing the approved investments in the HK Financial Model Portfolios, I like to take a big step back to see if there have been major changes in the investment universe that require a rethinking and makeover of our investment approach.

I liken this to the expression – Seeing the Forest for the trees.

The following is technical article about Index and Factor Investing. Please take your time reading it as it builds on the reasons why we have updated our investment methodology. Or, just skip the technical stuff and go straight to the end of the article to read “The Bottom Line”.

Three Investment Management approaches

Traditionally, when it comes to investment management, the conventional management approach attempts to identify mispriced securities. They rely on forecasting to select “undervalued” securities, this is known as market timing. There is a certain appeal to this approach because it assumes that a manager has unique knowledge or an edge on the market that no one else has. There is a mystery to it.

In today’s world of high speed everything, any information about a security is quickly disseminated, resulting in the updating of the price of a security almost instantaneously.

It is very difficult for conventional managers to outguess/outperform the market consistently over the long-term. In fact, conventional investment methods have low odds of success. According to research by Dimensional Fund Advisors, over the past 20 years, ending December 31, 2018, of the 2,414 equity mutual funds at the start of that period, only 23% beat their benchmarks. For the 1,826 bond funds over the same period, the success rate was only 18%. This approach also generates higher expenses, trading costs and has additional risks.

Then came along Index management – a strategy of following a commercial index while keeping expenses low. The objective is to match an indexes performance. However, an index fund has restrictions as to which securities to hold and when to trade. These are not the choice of the manager. This approach prioritizes low tracking error over higher expected returns.

This approach was a breakthrough. In 1974 John Bogle founded The Vanguard Group. He started an early index fund on December 31, 1975. By 2009, Vanguard was the largest mutual fund company in the United States. A key reason to Vanguard’s success has been keeping expenses low for investors, and acknowledging that by harnessing the market’s power, investors put their collective knowledge to work in portfolios.

HK Financial has included Vanguard mutual funds and exchange traded funds in our Model Portfolios since our inception in 1999.

The Factors based approach to investing incorporates the academic research conducted in 1992-93 by Eugene Fama and Kenneth French. Using historical prices, they identified several “Factors” of higher expected returns. Through a disciplined approach in the investment portfolio design, implementation and deployment of mutual funds, the objective is to capture these “Premiums”. In order to be included as a Factor, the associated premium must be: Sensible, Persistent, Pervasive, Robust and Cost-Effective.

Academic Approach

While many of the greatest advancements in finance have come from academia, it has been computing power that has tested and validated these theories and brought them into the practical world. Here are some of the key theories that have advanced investment research.

In 1952, La Jollan Harry Markowitz conducted his groundbreaking research on Diversification and Portfolio Risk, known as Modern Portfolio Theory (MPT) for which he was awarded the Nobel Prize in Economics in 1990.

MPT was adopted in the early HK Financial model portfolio and continues to be central to our asset allocation philosophy. Most of the mutual funds and exchange traded funds in the model portfolios consistent of indexed funds.

In 1964 William Sharpe conducted his research on a Single-Factor Asset Pricing Risk/Return Model, referred to as the Capital Asset Pricing Model (CAPM), for which he was awarded the Nobel Prize in Economics in 1990.

In 1966 Eugene Fama at the University of Chicago, developed the Efficient Market Hypothesis (EMH), it’s central investment theory is that all information is contained in share prices. He later won the Nobel Prize in Economics in 2013.

More recently, in 1992 – 1993, Eugene Fama and researcher Kenneth French, developed the Value Effect and Multifactor Asset Pricing Model, often referred to as the Three Factor Model.

While the HK Financial Model Portfolio continues to include Index Funds, the Factor investing approach is now included in the mix.

The Three Factor Model is an attempt to draw on research to measure market returns.
By using big data, they observed Factors that were were a differentiation in long-term market performance. These are:

1. The size effect is the tendency of stocks with a small market capitalization to outperform stocks with a large market capitalization over the long term. (i.e. small firms outperform large firms). Small minus Big (SMB) offers a Premium.

2. The value effect is the tendency of stocks with lower price-to-book ratios (value stocks) to outperform stocks with higher price-to-book ratio over the long term. The relative price (the price of a security as it compares to another) is a Factor (i.e. value stocks outperform growth stocks). High Minus Low (HML) offers a Premium.

3. Profitability is another observed Factor, in which firms that have a higher profitability outperform those that are less profitable. There are several ratios and measures of profitability. One example would be EBITDA. It is an assessment of a firm’s operating profit as a percentage of its total revenue. The formula is: Earnings Before Interest, Taxes Depreciation and Amortization (EBITDA) .

William Sharpe’s Single Factor model was the starting point for Fama and French’s research. Data shows that the overall market (or an investment portfolio invested in the market) less a risk-free return offers a Premium.

The Single Factor Model is described as the Market, as follows:

(The shaded area in the diagrams below are a generalized illustration of where the Factors can be observed in order to target and realize the Premium).

Then the Size Effect can be described as follows:

 

The Value Effect can be described as follows:

And the Profitability effect can be described as follows:

An observed Factor offers the opportunity to target and gain higher expected returns over the long-term. By structuring the portfolio to look for and pursue Factors, it is possible to capture the premiums observed over the long-term.

It takes a very disciplined management approach to capture the Premiums and this is a relatively new approach to investment management.

More recently Fama and French’s research have expanded their model to include other observed Factors including: Momentum, Quality and Low Volatility.

There are also two identified Premiums when it comes to fixed income (bonds). These are:

Term Premium – Longer vs. Shorter maturity of bonds
Credit Premium – Lower vs. Higher credit quality of bonds

The Bottom Line

We believe that no two clients are alike. That is why we believe in and offer the financial planning process to help you achieve your unique goals and objectives. We believe that people want to live fulfilling and meaningful lives. Financial planning is our way to prepare you for life’s twists and turns.

The financial planning process includes investment management. It’s purpose is to help you diversify and allocate your investments so that you can do whatever you choose, including: accumulate funds for financial independence, manage distributions during retirement, save for children’s college expenses, purchase a home, etc.

The above Seeing the Forest for the Trees is our attempt to show the differences in investment management approaches. Based on our research, we see the benefit of investment management that attempts to capture the Premiums associated with Factors of higher expect returns. We believe this approach (along with Index investing) is in your best interest and as a result we have adding Factor investing as core to our investment philosophy. They are now part of the HK Financial Model Portfolios.

To find out how we help our clients, please visit our website: www.hkfinancial.com