Utilizing Risk Factors in Active Management

Utilizing Risk Factors in Active Management

In this episode, we detail the importance of Barra Risk Factors in active management and how these metrics can provide a clearer picture of how managers are actually investing and the portfolio tilts they could be having.

KEY TAKEAWAYS:

  • Factors are characteristics relating to a group of securities. They can take the form of financial metrics, valuation, multiples, growth rates, leverage ratios, market sensitivity
  • Factors can give you a more complete picture of what’s going on in a portfolio and provide greater return transparency
  • For advisors, utilizing risk factors can help in ensuring greater diversity of return drivers from your asset managers
 
 
 

TRANSCRIPT

Ben Youngdahl:

For us, you know, when we build portfolios, it’s not simply about just picking the names that have the factor exposures that are favorable or in line with our philosophy process. I’m a sports guy and even here in Denver, I think we can all concede that Tom Brady is the greatest quarterback of all time. If we were to take 45 Tom Brady’s and put them on an NFL team, they’re not winning very many games. So as an active manager, it’s important, obviously, we want to look for names that have the exposures that we want, but we also want to make sure that everything fits together and is diversified by not just factors, but also many other drivers of return.

Jim Stamper:

Hello and welcome to the QPD podcast. I’m your host, Jim Stamper director of institutional sales here at Cambiar Investors. On this episode of the show, we’ll be diving into the importance of MSCI Barra factors and how these metrics are utilized within active management. My guest today is Ben Youngdahl, director of analytics at Cambiar Investors. Ben has over 12 years of industry experience spending the last eight at Cambiar. Ben oversees the firm’s risk analytics and reporting, working closely with the investment team and sales department to better understand both security and portfolio level risk. Ben, welcome to the show.

Ben Youngdahl:

Thanks Jim. Happy to be here.

Jim Stamper:

I’m excited about this. We’ve talked a lot about risk factors and how we incorporate them in active management. I think for our listeners, it’ll be interesting for them to understand how that actually works at an asset management firm. So before we dive deep into the actual discussion, can you provide a brief overview for our listeners as to what risk factors actually mean?

Ben Youngdahl:

Yeah, sure. It’s a good question and a great place to start. When you think about just factor analysis, broadly speaking, it can be a little intimidating or daunting, but it really is pretty simple. A factor is just a characteristic relating to a group of securities. That can take the form of a particular set of financial metrics, valuation, multiples, growth rates, leverage ratios, market sensitivity, something as simple as that. It can even be something even simpler in terms of just exposure to a particular industry or a country or things like that. But really it just needs to be a characteristic that can explain a group of securities and how they perform typically over time.

I think there are two real requirements in terms of what defines a factor and that needs to be that it historically has shown a degree of importance in explaining the risk and return of that group and it must be pervasive throughout the model. It can’t only apply to some sub-sector or some little piece of the overall universe. Finally, just kind of thinking about these ideas more broadly, why is it important? Factor movements can have major impacts on equity market performance, and thus an understanding of how a portfolio index is exposed to these factors are critical.

Jim Stamper:

Ben let me ask you this, just on that topic, you talked about explaining risk and return. I feel this, factors is newer to the marketplace because for years, managers would do attribution, look at returns, look at stock level. When you think about factors now, what’s different, for lack of a better word, with respect to how you’re evaluating a portfolio’s risk or return and incorporating factors into that.

Ben Youngdahl:

Yeah. I don’t know if things are necessarily different now. Factor models have certainly improved over the last few decades and will continue to do so. Obviously, the stock market here in 2022 is not the same as it was in 1982. So it’s important to have a model that recognizes that. I think in terms of understanding or measuring performance of markets and portfolios, one major advantage of factor analysis over just looking at sector attribution or things like that is that it’s going to give you a more full picture of what’s going on. For example, if we were to run sector attribution over a quarter, that might show that an overweight to a certain sector was important. Well, maybe that sector just has, more value factor or more beta factor, more momentum. So when you’re running this typical sector, country attribution, that’s possible that you’re going to be missing things. What factor analysis does is just give us a more complete picture and understanding of what’s going on.

Jim Stamper:

That’s great. That’s probably a good segue in my next question, because I want this podcast to really talk about how factors are incorporated into active management. When you think about factors, my guess is our listeners would think a lot about beta, certain ETFs that are focused on a certain factor. So how does an active manager, someone who’s concentrated like Cambiar with respect to their holdings, incorporate factors into their analysis of risk?

Ben Youngdahl:

Yeah, it’s a really tough question. If we were a top-down manager and we were holding two to 300 securities, I think it’d be pretty simple. You just go for the securities that most closely resemble the traits and factors that you’re looking for. When you’re running concentrated 40 stock portfolios and you have to do so in a way that they’re not only concentrated but also diversified, factor analysis becomes even more important.

One thing we’ve seen is obviously we want to look how our positions from a factor basis based off value and quality and momentum and beta, but we also want to make sure that our sources of risk and return are diversified as well. And so for bottom-up managers, that means that we don’t want to have too much factor exposure in certain areas. Here at Cambiar just use an example, we employ kind of a quality and a value approach. Obviously, we’re going to want exposure to those two areas, but having too much exposure to those areas can be just as dangerous as not having enough. We want to make sure that we’re diversified by factors of course, but also sources of return, whether that be stock specifics or more factors.

Jim Stamper:

Let’s talk a little bit about Cambiar specifically, you touched on it, but when you think about the Barra factors, there are a number of them. I can’t imagine every manager is focused on all of them. So thinking about how Cambiar is constructing portfolios, thinking about risk, are there certain factors that are more relevant to the way that we’re running money here at Cambiar versus maybe an index or other managers?

Ben Youngdahl:

Yeah, absolutely. We think about factors broken into two categories. We’ve got factors that are absolutely critical to our philosophy and process. These are factors that have had historically generated strong risk-adjusted returns. We believe in them, they’ve been tenants of our quality and value philosophy for a long period of time. Those are the factors that we actively want to seek out and without getting into too much detail, I’d say that quality and value are the two categories of those factors that we’re particularly more focused on. Then there are the factors that aren’t necessarily a part of our process, but have historically shown a tremendous amount of importance in terms of explaining your risk in return. These are factors that we need to be aware of how we’re positioned because if you’re not aware of them, you can get yourself into trouble.

I think momentum is probably the best example there where, we’re a value shop and in many instances, we’ll pick names that are out of favor because we believe in the story and where we believe that they’re going to turn things around. In many instances we’re looking at names that have lower momentum that said, if we get ourselves into a position where we’re either extremely low momentum or extremely high, we want to avoid those areas as it could suggest that a red flag where it’s just something that we might want to dig into a little bit further.

Jim Stamper:

So Ben, you talked about certain factors already within the Cambiar process that are more important quality and value were two you highlighted. When you think about portfolio construction and sectors, I know in our discussions internally, even that certain industries and sectors have more favorable Barra characteristics within quality, for example. When you’re thinking about construction, how do you balance that out, knowing that might naturally gravitate towards certain industries or sectors that have more of the factors that we seek?

Ben Youngdahl:

It’s a great question and I think you hit on it a little bit. It’s all about balance. I think one sector that screens very particular way in terms of qualities, financials, and financials in aggregate doesn’t look great on some quality metrics in particular profitability or leverage. Does that mean that we don’t own any financials because it doesn’t fit our mold exactly how we’d like, absolutely not. But it does mean that the factor exposure we have within financials needs to be balanced in other areas of the portfolio. Financials in terms of values, it’s a great source of value, lots of really low price to book names and so if we’re looking for some balance between value and quality, it’s a good place to be. It just means that we have to really understand and be aware of the exposure that’s provided by that sector and make sure it’s balanced in other areas of the portfolio.

Jim Stamper:

Looking at small and midcap asset classes, volatility can potentially be higher, let’s say than large cap. Does that change our thought process with respect to Barra? How does that fit into the selection process? Thinking about asset classes.

Ben Youngdahl:

In general? No, we apply the same sort of process with the way that we manage factors throughout all of our asset classes and regions. That said there are certainly some distinct aspects of the down cap asset class. That’s really important to be aware of. I’d say the number one thing is when you’re looking at your overall risk and return profile, one interesting thing that Barra can do is break it up in between how much of your risk and return is going to be explained by company-specific factors that the model can’t recognize and how much of it is going to be explained by factor exposures. Within small cap asset class, in particular, those names are going to have a lot more company-specific risk associated with them. It’s important to understand that you really have to get your positioning right in small cap because if not the company specifics can really throw things off.

So that’s the first thing to understand. I think the second thing pertaining to Small Cap is that selective avoidance takes a much greater level of importance with that asset class. In particular, I think the best example is looking at microcaps. Anything below that kind of 500 million mark, you’re getting uncovered names that there’s not a lot known about that can really move on their own irrespective of their factor exposure. It’s really important to understand what we need to avoid and what’s going on with some of those areas.

Jim Stamper:

That’s great, Ben. This is a good segue in my next question. Just talking up about the volatility within small and mid asset classes. There’s been meaningful drawdowns over the past few years, when you think about strong performance, that Cambiar showed in both of those strategies, small and mid, especially in the downside. How do you think about that with respect to Barra, and the downside capture that both of these portfolios have exhibited?

Ben Youngdahl:

First of all, that’s a tough question for any manager. It’s even a bit more tough for Cambiar, given that the way that we utilize factor analysis, it’s not a front end tool. We don’t use it as a way to screen out pieces of the universe. On top of that, we’re constructing concentrated portfolios using a bottom up fundamental process. Because everything is so baked in it’s really difficult to sign some sort of contribution to one particular piece of the puzzle there. Let me start by saying this I guess, there’s no question that certain factors have historically performed better or worse during periods of market turmoil. That’s been pretty pervasive over the last four to five decades and so having a first and foremost, having an understanding of which factors perform which way is absolutely important.

I think our PMs do a great job of that. That’s where you need to start. I think from there, when you look at just purely in terms of Cambiar’s performance over these periods, I think the next thing is, we talk about it being baked in, but everything has to be fitting together here. So it’s got to be purely collaborative from the PM’s understanding, their positioning, the analysts buying into our philosophy and process and populating the names kind of fit our criteria and then making sure that we’ve got the discipline to kind of execute on those across multiple levels.

Jim Stamper:

You touched on it and I want to sum up everything we’ve talked about today, it’s been a great discussion. Just thinking about the most effective way to blend working with Barra and then again, you touched upon running bottom-up, concentrated portfolios. It seems almost counterintuitive that you would incorporate factors when there’s so much stock specific risk in a 30 or 40 stock portfolio. To be effective at this, blending analytics with bottom-up fundamentals, what’s the best way to accomplish that goal?

Ben Youngdahl:

I think a team approach is the best way to do it. We’ve obviously got PMs who are acutely aware of how the portfolio is positioned. They know exactly why they want it positioned in that way to provide this level of return transparency, both for us internally and also to our clients who are really trying to kind of fit each of our portfolios into their overall allocation, I think that’s really important. But I think utilizing a team approach where the PMs kind of have this overarching structure, but the analysts also understand what we’re trying to do, but also understand the importance of company specifics and knowing that your factor positioning isn’t going to matter at all, if you don’t get the stocks, right.

I think when we look at this balance between the two, we would like to have the majority of our risk and return coming from companies’ specifics. That’s our core competency. It’s what we’ve done at Cambiar for decades. We absolutely want to make sure that we’re not diluting that process, but also just supplementing that process with an additional layer of risk analysis to make sure that the things that we can’t control outside of the company specifics are going to be favorable for us.

Jim Stamper:

Ben, one question I wanted to ask you that I think our listeners will appreciate, especially the ones out there that are financial advisors. A big question and challenge that they have is constructing portfolios today, ensuring that they’re getting the types of diversification that they want ensuring that the manager does what they want. I’m hoping that this conversation will benefit them. How would you talk to a financial advisor who’s thinking about constructing portfolios, incorporating factors. They’ve heard a lot about it, how do they effectively do that?

Ben Youngdahl:

Yeah, it’s a great question, Jim. I think that there’s a number of similarities between how we use factor analysis here at Cambiar and the way that we construct equity portfolios that apply to how an advisor could use the same analysis in terms of building up their overall allocation, using a number of different managers. I think one good example that might help understand this is, here at Cambiar, we employ a relative value approach with a specific bias towards quality names. We get lumped into some of these peer groups with value managers that are much deeper value and typically have exposures to some of the lower quality areas that aren’t a part of our process. If you just look at how that’s played out over the last couple years, quality took a huge amount of importance over the COVID decline.

So managers that had a little bit more higher quality did better there. Since the vaccine news dropped in late 2020 and the recovery trade kind of took off from there. A lot of those lower quality names ripped and have done really, really well, obviously we’re bias and we think that a higher quality approach is going to work over time, but it’s really important for our advisors to understand what type of manager they have and not just look at that overarching bucket of being value or growth or something like that.

Jim Stamper:

That’s interesting. So my question back to you would be, so if an advisor’s comfortable with that deeper value trade, the one that’s lower quality, that’s worked since the vaccinations that’s where they’d want to be, but they need to understand that’s the type of value manager that they’ve hired?

Ben Youngdahl:

Right. It’s all about understanding your return transparency. So what are you getting out of that manager? It’s also important to understand how that’s fitting in with your other managers in your docket there. If you’ve got a growth manager that’s extremely aggressive, speculative growth, way far over to the right, maybe you want a deeper value manager, maybe having a manager that’s a little bit higher quality isn’t going to fit, but regardless it’s all about making sure that everything fits together.

Jim Stamper:

Thanks Ben. This was a great discussion, really enlightening and I’m pretty sure that with all the volatility we’ve seen just already in 2022, that these factors are going to become increasingly important. Thanks for providing your insights today. I really appreciate your time. To all of our listeners. Thank you for tuning in. If you’re looking for more information about the strategies mentioned today, please visit cambiar.com. I’m your host, Jim Stamper until next time, take care.

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Disclosures

Certain information contained in this communication constitutes “forward-looking statements”, which are based on Cambiar’s beliefs, as well as certain assumptions concerning future events, using information currently available to Cambiar.  Due to market risk and uncertainties, actual events, results or performance may differ materially from that reflected or contemplated in such forward-looking statements.  The information provided is not intended to be, and should not be construed as, investment, legal or tax advice.  Nothing contained herein should be construed as a recommendation or endorsement to buy or sell any security, investment or portfolio allocation. 

Any characteristics included are for illustrative purposes and accordingly, no assumptions or comparisons should be made based upon these ratios. Statistics/charts and other information presented may be based upon third-party sources that are deemed reliable; however, Cambiar does not guarantee its accuracy or completeness.  As with any investments, there are risks to be considered.  Past performance is no indication of future results.  All material is provided for informational purposes only and there is no guarantee that any opinions expressed herein will be valid beyond the date of this communication.

Securities highlighted or discussed have been selected to illustrate Cambiar’s investment approach and/or market outlook. The portfolios are actively managed and securities discussed may or may not be held in client portfolios at any given time, do not represent all of the securities purchased, sold, or recommended by Cambiar, and the reader should not assume that investments in the securities identified and discussed were or will be profitable.