Factor Investing Can Keep Active Management Relevant

Despite its recent troubles, active management remains relevant, but its future “lies in low expenses that allow investors to enjoy a comfortable share of returns,” according to a recent article posted on ETF.com.

The article cites comments by Tom Rampulla, managing director of Vanguard Financial Advisor Service, who argues that active managers have to employ factor and smart-beta investing, referred to as an “evolutionary stage of active” that can “benefit client portfolios.”

According to Rampulla, active management “simply costs too much,” and he argues that the underperformance of such managers is worsening, exacerbated by the glut of investment professionals in the market. But this doesn’t mean that active managers can’t be successful, the article says. It cites data collected over the past several decades showing that certain factors can help securities outperform; market, low volatility, value, size, momentum, term and credit. “Studies show that factor exposure is responsible for the majority of active managers’ success in delivering excess returns” the article says.

Rampulla explains three caveats regarding factor investing:

  1. Factors, he says, don’t necessarily work individually– but can be combined to reduce overall risk. “That can create a powerful combination.”
  2. Factors tend to be cyclical and, therefore, can lead to periods of underperformance. So, advisors must act as “behavioral coaches,” encouraging clients to be patient during such periods, which can sometimes drag on for years.
  3. Factor investing should be less costly in order to boost portfolio returns.