Well, welcome back and we are going to start by discussing what I think is one of the most exciting changes that have happened in investment management in the last decade at least. That is this trend towards factor investing or what some people called smart beta. To understand factor investing and smart beta a little better, you have to think back to how we traditionally used to think about investment choices that you and I had. The traditional choice was a choice between what they call active and passive. Passive is put your money in the index S&P 500, [inaudible] 100, doesn't matter. Just put your money in the index and forget about it. Don't try and outperform the index. On the other hand, we had active management where a manager who had skill that she or he would bring to the table would be able to somehow use the skill to outperform the index, and that's why you would give your money to this manager. Active management tends to be expensive, tends to be inconsistent, but hey, if it works, you can do better than the passive index. That was the assumption. What is really interesting is this new emergence of this third way, it's not active or passive. What it does is what some people like Craig Lazzara from S&P called the indexation of a portion of active management. So what he means by the term indexation is that you take that portion of the value that an active manager brings. Take a portion of it that you can just convert into a bunch of rules, and just turn that into an index or a systematic set of rules. So there have been a very exciting range of new companies and products that have taken the systematic scientific component of what you used to have to go to an active manager for, and they've been able to deliver that in the form of a relatively inexpensive index. So you have this third way that is halfway between passive and active. It's active in the sense that it's not just the weighted average index. It is not just the cap weighted index like the S&P 500. So in that sense, it's active but it's passive in the sense that there is no subjective views being brought to the table. It's all rules-based. There is no human being who's exercising some sort of subjective judgment or views. So what that gives you is a way of investing that has most of the advantages of passive investing with the likelihood of out-performance that you used to be able to get from an active manager. So you can see why that has been one of the most dramatic advances in investment choices. So to understand this, what we're going to do is go all the way back. We're going to go back and understand the theory behind what makes all of this work. For that, you have to sort of start to think differently from the traditional way of thinking. So bear with me, I'm going to take a really bad analogy and see how far I can take this. This is the investor's view of a portfolio. It's a product. So when I go out and buy a product, it is essentially all packaged up for me by somebody, and that is what I am buying as an investor. I put my money in an ETF, I put my money in a mutual fund. I am buying essentially a packaged product that for some reason I've decided I like. This is an investor's view. However, you could also look at it from an asset allocator's point of view. The asset allocator has traditionally gone in and said, "Well, what are the components? What are the pieces of the puzzle that I can acquire and put together?" So an asset allocation view is essentially to look at the components that make up your product and decide exactly what components I should use and in what ratio. That is asset allocation. That is still fundamentally different from the way a factor investor looks at it. A factor investor looks at not the expensive packaging and not even the components of the product, but it looks through all of those to the true drivers, to the actual nutritional content, to the underlying reasons why there is any sort of an excess return at all. Now, you can see why this is really interesting and exciting. Because if you can look through, if you can understand what's really driving your portfolio, and if you can harness those drivers effectively, inexpensively, reliably, then you actually don't care about the expensive packaging. The analogy that some people have used that I like a lot is, it's a way of thinking about your investing that is similar to how we would like to think about our health. We have to look at it like healthy eating, requires us to look past the expensive packaging of the product and understand what the nutritional content of our food really is. Exactly in the same way, a factor investor is trying to look past the expensive packaging of products that are being pushed to us in the market and say, "What's really driving this, and can I get that in an inexpensive way?", "What's really driving the returns of my portfolio, and do I really need all this packaging that I'm obviously paying for?" So I'm not going to push this analogy any further. If it works for you, great. It certainly worked for me and I hope it helped. The trick, of course, is to understand what are these drivers, what are these nutrients, and how do I get them. That is the subject of this entire section. So if you believe that factors are sort of nutrients, what we have to do is figure out what are the nutrients that are available to me and what are the nutrients that really matter to me. Because the nutrients that matter to me might be different from the nutrients that matter to somebody who is much younger than I am and who has many years of investing left in their career, whereas I might not have that same view. So what these underlying drivers are, are what we call factors. So what is a factor? A factor is simply some sort of variable. It's something that influences the returns of an asset. It represents something that's common to a whole bunch of stocks. It's something that's common. It's commonality. So when that variable rises, that affects all of the stocks that somehow have an exposure to that factor. It is something that is intrinsically outside. It is, by its very nature, outside of the stock. The key thing about it is, if you expose yourself to this factor, if you expose yourself, if the stock is exposed to this external factor, then there is a reward. In other words, there is a risk premium associated with the factor. We call this the factor premium. The factor premium is the excess return that you get if you're willing to expose yourself to this factor. What are these factors? So there are, generally speaking, three types of factors. The first is sort of macro factors. Things like growth, inflation. You could imagine that when inflation rises, there are some stocks that are going to be affected by it. So in that sense, it's a factor. Industrial growth could be a factor. When there's growth in industrial production, it's going to affect some stocks. When industrial production falls, it's going to affect some stocks differently. That's an example of a factor. We tend not to use those in investing quite as much because it's not easy to buy tradable products that harvest that factor easily. So although you could certainly do this kind of macro investing and many people do, it's not the most inexpensive form of factor investing. There is another form of factor investing that people don't do very much of, which is what they call statistical factors or implicit factors. What that means is, it's some sort of a statistical artifact that we don't exactly know what it is, but it's there in the data. In other words, we can take a pile of stocks and we can just look at the data and we can see that, "Hey, these stocks all seem to move together when this one thing happens," and this one thing is simply that the stocks itself move together. So the commonality is intrinsic or implicit in the data, and as a result, it's a statistical artifact. The problem with that approach is, again, it's not easy to trade it because it's not obvious sometimes what this factor is that's been driving these stocks together. But it's a good way of looking at it, and statistical factors or implicit factors are very important in some other places, but not so much in factor investing. Factor investing is all about harvesting intrinsic factors that is intrinsic to the stock. So for example, style factors are the most common form of factor investing, and the common styles that you might be familiar with are value versus growth. So value stocks tend to outperform growth stocks. Similarly, momentum stocks. Recent winners tend to outperform recent losers. These are examples of factors that are intrinsic to the stock, and therefore, you can construct the portfolio of stocks that have a high degree of exposure to that factor. If there's a factor premium associated with that factor, like value, you can build a value portfolio that should outperform the growth portfolio. All right? So that is really the kind of factor investing that we're going to be talking about. That is typically what we talk about when we say style factors or factor investing, those are the most common. But before we can do any of that, we are going to have to really take a step back and understand what a factor model is, and we're going to do this in the form of a little bit of a history lesson. We're going to study the most important factor model, probably in all of finance, which is the CAPM. So we'll start with a simple model, which is the CAPM, and then we will see that there are refinements of the CAPM that will help us understand how these factors affect the portfolios. Once you're done with this, you will see that actually, it's very, very difficult to build a portfolio that is not affected by factors. In fact, the larger your portfolio, the more likely that you're actually just investing in the factor. So I'm going to end with this basic notion that whether you like it or not, you already are a factor investor. Because if you're investing in a portfolio of stocks, your portfolio's returns are dominated by a relatively small number of factors. So whether you like it or not, you're already a factor investor. What we're going to try and understand is what are these factors and how can I do a better job of using them in my portfolio since I'm probably going to be affected by the factors anyway. Thank you very much.
