Will a systematic investor need to change when markets are evolving – and specifically when more assets are being managed passively? Not really according to Mamdouh Medhat, research director and vice president at Dimensional Fund Advisors.
“It’s an interesting question. We’ve had the same investment philosophy, broadly speaking, since 1981. The idea is to take the best insights from financial science and apply them in an efficient way in liquid public markets. And nothing we’ve seen over these past 45 years has led us to materially change the idea that things such as broad diversification and efficient implementation continue to matter,” he says. He adds that the rise of passive is significant in the sense that we’ve had this shift very recently where there are now more assets in index funds than in traditional active funds.
“One thing that’s important to remember is that just because assets go into index funds does not necessarily mean that they’re buy-and-hold. What you’ve seen is that a lot of these index funds are used in a very active way. They essentially replaced the single stock or single bond exposure, and investors are basically using index funds now to express their views on a particular style, asset class or sector. It’s just a shift in the way we package up this information, but the information still makes its way into markets and thereby gets reflected in prices. This allows us to still rely on prices and markets in the way we invest,” he explains.
He adds that not all investors have the same preferences and they don’t have the same time horizon or risk aversion.
“The nice thing about the of concept of markets is that there is this equilibrium where demand and supply meet. One thing that people are often worried about when they talk about passive investing is that it will hurt price discovery and volume – basically all the inputs that we need to make our systematic investment philosophy work. That’s not what we’ve seen. There’s lots of academic studies that show that if there is any impact it’s still too small to be able to say that it has hurt price discovery. It also depends what kind of assets are moving into index funds. If it’s the assets that would have been used to trade on noise instead of trading on information, then it might actually help price discovery that some of these are going into more passive products,” he says.
Asked to explain what factors from academic research they are focusing on, Mamdouh Medhat says that in the equity space, there are three main drivers or factors – company size (higher expected returns from smaller companies), relative valuation (the less you pay the higher the expected return) and profitability (higher expected cash flow leads to a higher expected return).
“Taken together, these factors give us an evergreen framework that guides how we invest and they’re very complementary to each other. They don’t subsume each other. Particularly profitability is a great complement to pursuing the size premium and to value investing because it tends to allocate to the other side of the market,” he says.
Asked about the secret sauce and how to move from looking at the market using these factors to building a portfolio, Mamdouh Medhat says that there’s little-to-no secret sauce.
“Dimensional as a firm has always been very open about what the building blocks are and how we think about investing. We don’t think that the secret sauce comes from keeping your factors hidden. That will just increase the monitoring and governance costs for end investors. We publish most of our research, and we think that makes us all better and helps us understand markets better. The collaboration with the academics fits in that category as well. We think the real value comes from the integration of a highly rigorous scientific approach to investing and a very deliberate and efficient implementation of that research,” he says and explains that implementation for Dimensional starts with portfolio construction.
“How do you think about combining these factors into actual portfolios that you can invest in? What’s the investable universe? Are you going to hold everything? Are you going to hold only a slice of the market? How tilted is it going to be?”, he says and adds that designing portfolios is all about trade-offs.
Mamdouh Medhat says that where they really go beyond a typical index fund or a passive approach is in the implementation.
“Many passive approaches tend to sacrifice implementation efficiency in order to get a low expense ratio. They’re all about being cheap. We don’t believe that a lower expense ratio automatically means a better product. Yes, costs matter a lot, but some costs are not reflected in the expense ratio. For example, if you don’t rebalance frequently enough, you actually end up leaving returns on the table,” he says.
He explains that this is especially true when it comes to pursuing something like the size premium.
“Back when David Booth and Rex Sinquefield set up the company, they did so around the size premium – that was the differentiator. Today, we’re back to the size premium being a key differentiator. Basically, every other systematic or quant manager has sort of jumped on the wagon that says, oh no, you shouldn’t consider size, that size doesn’t work anymore. That’s of course driven by the recent strong performance of mega cap and growth companies in the US so it’s a very US-centric story. But a lot of it is also driven by the fact that the size premium is sensitive to implementation details because you’re trading in generally smaller, more volatile and less liquid securities. It doesn’t have to be the nano caps and the micro caps. There’s also a size premium when you compare mid and large caps. How you handle trading and how efficient you are in your implementation matters a lot,” he says.
Asked if he is seeing an increased interest in systematic strategies as an alternative to gain exposure to global equities after a long period where investors have selected to go fully passive, Mamdouh Medhat says yes.
“I think we are getting similar sort of thoughts from a lot of investors, particularly in the Nordics. It’s becoming apparent that while you’re getting a low expense ratio – and it’s nice to be able to hug the market at low tracking error – you’re also giving up a lot of opportunities,” he says and adds that they’ve seen a lot of interest in relatively low-tracking error solutions that still try to be more efficient than an index fund.
“It can be things like the types of exclusions that you do or smaller tilts to the factors. Just by defining your investable universe slightly differently than what you would typically have an index provider do, which is subjective and arbitrary anyway, can be quite material over the long term,” he says.
He adds that the concentration we’re seeing right now in many index funds is also something that has caused investors to rethink what kind of allocation they want to have.
“Not only do you have the US making up 65 – 70 per cent of your typical global index, but within the US, you have high concentration at the top of the market. Just the fact that you have such a large proportion of your assets in a few stocks with such high valuations is giving a lot of people food for thought. So, what we’re seeing is demand for doing some things around the edges,” he says.
He explains that he’s not talking about massive deviations from the market, which he doesn’t think many in the institutional space have appetite for right now.
“We’re seeing many investors in Europe and in the Nordics take a bit more of a home bias to curb a bit of that US exposure. Within the US, we’re seeing a bit more of a bias towards value securities and smaller securities. It can even just be mid-caps. As I said earlier, we’ve maintained the same investment philosophy, broadly speaking, for many, many years and what we’re seeing is that investors are coming back to that,” he says.
Mamdouh Medhat concludes the discussion by commenting on the wave of large IPOs coming to the market. “There’s a lot of talk about IPOs right now and this is one more example of where we have very good academic research that shows what investors should expect from a large IPO versus a small one. We’re also seeing some lobbying going on right now in terms of index providers trying to do some special rebalancing so you can get some of these larger IPOs into the index funds. All of these quirks and special things are some of the flaws of indexing. If you have the flexibility to stick to the research, then you can rely on the academic evidence instead of just being beholden to what an index provider thinks that they can get out of the lobbying that might be happening from some of the underwriting banks. The IPOs are great because it’s new blood into the market. But, looking at the long-term evidence, some of them have not been a good deal for investors in the short term and it makes more sense to wait and let the price discovery happen, then get in a little bit later – especially after the lockup period. If you have the flexibility to do that, as we do as a systematic but active manager, that’s one way of trying to be a bit more efficient than your neighbouring asset owner that is beholden to whatever the index providers think should come in and when,” he says.
