Morgan Stanley’s Slimmon on Factor Exposures

the best on the year. Now, one little wrinkle with that is that you know we have a beta neutralized long between the long and short legs. So what that really means is a little bit more, you know, a little bit more money in the low ball and a little bit less money in the high ball. When you do the long short factor that's the best performing on the year momentum and quality. I've also performed very well. Like I said, value is down. But the one thing I'll say about value is when you do long short

on equal weight basis, it's just down moderately. It's just that market cap weighted long short value is really getting harmed. And that's because of the FASTAUP performance of the largest most expensive stocks on the year. Interesting.

done okay, but it hasn't been spectacular. But overall, I look at you know, what works long term, quality and sticking with winners. Usually there's some fundamental backdrop behind it, and this year hasn't been really different.

I think One of the things I love about this business is, you know, I played college sports and competed as a junior, and I love the investment business because there's you know, there's a you know, there's score at the end of the day, and you can't make up you know, there's no room for commentary on the scoreboard.

And I think that's true of sports also. But I started, you know, my career at a at a private bank in New York out of college that had a you know, an investment management arm and I never you know, they had about thirty research analysts that cover all these different industries, and you know, I was right out of college and I was in the research department, and they all seemed

very very bright. And they had an investment committee that met once a week and they would debate the investments and then they put the investments into the fund based on you know, what the research analysts would recommend. And they all seem very very bright. Except I noticed after being there a couple of years that the performance was, yeah, it wasn't it wasn't terrible, but it was never really really that good. And our outperformance and I think, now,

you know, what we've learned since the eighties. Is well, when you have an investment committee that meets once a week. Uh, you know, the market is more you know, kind of reflexive than that. Uh, management by committee hasn't done as well as managed by kind of uh lead or or closely Philip Kim and I run the strategies. I think

that's That's another thing. And then most importantly, we've learned that when you own you know, one hundred plus securities in your benchmarks to the S and P, it's really hard to perform over time. So that was the first experiences that led me to believe huh, okay, uh, when I start this, you know, I started the group. Those experiences didn't work, you know very well. Maybe I won't,

I won't mimic that. Then I went to the Universe Chicago Business School because I wanted to you know, kind of hardcore finance experience, and I took Gene Foma's course and Ken French's course, and I learned that, you know, kind of there's a quantitative side to investing, and that buying cheap stocks outformed buy expensive stocks. Uh. And uh, you know, things like momentum actually work. And that had nothing to do with fundamental research it had to do

for the quantitative side. And I think since that time in business school and even morning Star has come out and proven studies that you know, kind of two thirds of it in manager's return comes from its factor exposure. You know, Chris is loving what I'm saying now, But the reality is is that think about the year twenty twenty one. Growth in twenty twenty twenty one got so expensive that going into twenty twenty two, it didn't really matter what growth manager you chose. It really didn't matter

what growth stocked your own. You went down a lot. So it really the decision was not which growth stock owner, which growth manager invested in, is should I own growth stocks? And so that led me to HM, before we get to the fundamental research of analyzing a stock, maybe we should understand what factor exposure we're getting when we buy a sock. And look at the last month and a half,

did it really matter what financials you own? They've all done great now, maybe some have done better than the other, but they've done a hacker a lot better than they've done recently. So it was a factor shift. And so I think that's the second experience, and then third coming out of business school, I wanted to stay in Chicago. My wife got a very good job in Chicago, and I wanted to really be start my career on as a research you know, going back to the buyside. But

I couldn't really get a job. That was in nineteen ninety one. We're in the depths of a bear market, and I started my career at Morgan Stanley in their prior wealth management office area. At the time, we didn't have a you know, a broad distribution of wealth management financial advisors, so we had this small group that kind of cover family offices, smaller institutions and show them, you know, investment ideas. And what I observed was a couple things

from that experience. Number one is clients generally don't care whether they own growth, their value or large cap mid cap. They want to make money and it doesn't really matter where it comes. And the problem with that is that their patients duration of investing in a style of investing is not consistent with the duration which a style can go out of favor. So inevitably, you know, after about two years of your value manager underperforming the S and P,

the client starts to go with me. You know, maybe we should get rid of them, and so eventually say oh yeah, yeah, wah, we should definitely get rid of that manager. And it always has happens right before that style comes back into favor. So the point of this was is that Okay, the style box driven managers, they get all their money after they've done well because the tear sheet, your tear sheet only tells you what they've done in the past. It doesn't tell you what will

happen in the future. So the combination of the tear sheet plus the emotional biases to buy things that are working that are priced up in the equity market, which is crazy. I don't know of any other market in the world where when things go down prices are marked down, people more willing to sell, and when we're marked up, they're more willing to buy, except for this market. But

that's the reality. So when things have done poorly, clients didn't want to buy, they wanted to sell it, and so it led me to believe let's see, let's put all those experiences together. We know we need a small team. We know we need a portfolio that has a limited number of socks. We know we need to focus on a quantitative approach first, but quant doesn't explain everything, just a portion. And thirdly, we can't be stylebox driven because at the end of the day, clients really they're not

clientbox driven. Hey I did great, I lost you less money than the growth index. Yeah, but you want to perform the SMP, so let's move to something that's performed the S and P. So by the very nature of all these style boxing we're kind of setting people up to fail. And so that was really, you know, kind of the experiences led me to believe. In two thousand and three, I raised my hands said I don't want

to cover these clients anymore. I want to start this group that will be at the at the you know, at the at the base of what we do is factor analysis, quantitative analysis. But it won't be just that. We're going to have a fundamental group that focuses on fundamental research so that we once we get the factors right, we can overlay it with what's the best you know, value socks oone, what's the best financialist to own? And that,

you know, that's what we started. Uh and I started oh four Philip Kim, who had a much deeper quantitative background than I did join me late oh four, and you know we've been off to the running ever since.

active share is really high. And remember what I said before, What studies have shown is that managers that have higher active share ten not all. It was ten to outperform managers that are benchmark huggers. Because at the end of the day, if you have high active share, you differ from the index, and therefore your people are going to find out pretty quickly. You're either doing a good job or you're not. You're not going to gradually underperform. So

we by having twenty stocks, it keeps our active very high. Now, to be clear, you could have high active share because you own lots and lots of socks, none of which are in the index. But there's another measure that's very very important to us, and it's called your tracking air, and your tracking air measures how volatile your fund is relative to the benchmark. Now it's not your beta because

that just measure is relative to the index. But so in other words, if I had lots and lots of stocks that weren't in the index, so I owned a hundred socks none of which were in the index, well then I wouldn't move with the index much, and so

my tracking air would be very very high. But if I could own twenty stocks, all of which are in the index, but they're not all you know, kind of focused on one theme or one bet, then I could keep my tracking air down and all Again, the academic studies show high active share and only moderate tracking air, you know, leads to success. So that's where we start. We start with. Every time we look at a stock. We say, well, if we add a stock, you know, we got to take one away because we want to

keep it at twenty. But if we add that stock, will that increase our tracking air which we don't want to do, or lowers our tracking. So broadly speaking, if we liked, say value, and we own only financials, well, adding another financial would increase our value exposure, but it would also increase our tracking. So we think in large a lot about how to add or change stocks that give us the factor exposures that we want but don't necessarily they're not correlated to other stocks in the portfolio.

And that's how we you know, we start the the process and then we begin with okay, well, what factors are working? We want to stay in the game. We don't want to be you know, all in value where I'm sitting there and saying value work long term, and you're you know, you're mister, mister or missus client, you're saying, yeah, but value hasn't worked for three years. Right. We're looking at what factors are working from a price performance basis and then making an assessment and it continue to work

in the future. And that assessments based on is the factor expensive or cheap. So we're looking at valuation and momentum of the factor and assessing can it work in the future. And if you look around the world, I've heard a lot of people tell say, you got to buy you know, especially in Europe, value is really cheap. Well, it's really cheap, but it had to work for a very very long time, so it hasn't pay just because

value is very very cheap, it hasn't worked. And so again we're thinking about how to bias the portfolio from a quantitative standpoint first in each part of the world US, Europe, Japan, Asia, extrapan from a factor standpoint, and then and only then picking stocks that give us that appropriate factor exposure that we like for a fundamental, pure fundamental reasoning. So they

call us a quantinmental team quantinental philosophy. I just know that pure quants try to diversify away the fundamental side, and my roots started with a fundament. I know there's value added good stock picking, but I'm also well aware that at the end of the day, you got to get your factors right first, and that's the most important. That's the core of what we do.

kind of goes to what you're saying. When they fire you, you start out performing, and then you know, I think a concentrated factor portfolio makes so much sense because you know, what people don't really understand is, after so many assets, so many alphas, however you want to say it, you don't get very much diversification benefit.

market factor, you know, as a value factor. You know, what do you how do you think about constructing value? Is it a composite of a lot of different metrics. You don't have to like get into them. But or how do you broadly think about a constructing a value factor?

works huge. Right, So twenty twenty, in the midst of COVID, if you had just bought stocks, had just gotten cream because you know they were casinos or airlines or cruise ship. If you just bought those, you did great. But you know that's true of nine also two thousand and nine. But most of the time price book doesn't work. So

on a calendar your basis. So it's great in academia to talk about deep value as a factor, but in the reality of what we're trying to apply, Oh, we can't just look at deep value because most of the time, it doesn't work, and I can't keep saying, hey, don't worry, well, there will be a time when it'll work again. Clients don't They're gone, They are gone. How many clients we're buying into deep value strategies in you know, you know, in twenty twenty into covid u, They how about it?

In eight? No way, but that's when they work. So it's it doesn't it does, It's not practical to the emotional biases of this business. So you move to earnings yield, which doesn't do long term as well, but it has a more consistent time frame. So we look at price to book, but I think over time, we you know, we look at things like earnings yel more closely. But we so we have a deep value factor, we have

a stable value. We've looked at a gazillion different kind of metrics quality, growth, value, but we've learned to try to keep it simple and don't make it too complicated because you're never going to kind of find only stocks that fall into into one bucket. But I would say, you know, practicality, it's it's very, very hard to run a deep value book when clients can movement any in and out of your fund or strategy on a you know,

on a daily basis. If I if I ran a fund that was locked up for ten years, I just go buy a lot of really really cheap stocks.

in the United States. And then the bigger question is is around the kind of much maligned topic of factor timing. You know, you mentioned factor timing. I think you did, you know, I think you were hinting at that and using momentum to time factors. You know, I'm informed by the paper from aq R factor Momentum Everywhere, which basically

shows that factors themselves have momentum. So you know, I would love to know is you know, is that your main input in how much tactically, are we switching between these factors or are you uh, you know, as Cliff says, sitting a little.

want to allocate to a country. For instance, when a factor model is saying, hey, you should buy high dividend yielding quality stocks, that's usually a sign of a risk off market versus a mark versus word that says hey buy growth or buy value, that's usually a risk on market. So we will allocate and buyas the portfolio from a regional standpoint where we see the factor models are setting the strongest, strongest system signal. Now stay within the the

guidelines of you know, kind of requirements. We never can go more than seventy percent in the US or seventy percent outside of the US, so we will all there are certain guidelines, but broadly speaking, it has paid to have a higher allocation to the US within a global strategy, and that's one of the reason why we started global strategies was simply kind of my kind of picture advertisement, which is, hey, international manager can only buy non US A global manager can buy if it happens to be

the best the best era. But look, I'm you know, like I like to say, I'm agnostic towards regional allocation. I'm agnostic towards styles. I'm not here to convince you to buy any sales. I just want to stay in the game in terms of factor timing. Very interesting, Chris.

So when I started these strategies, especially on the institution side, So I started going on and I you know, I'd be taking around the world these very large institutions and I'd say, well, you know, we're starting these you know these we run these factor models and there's a factor

component to them. And I would get a lot of pushback because at the time, it was kind of ten years ago, people just started about factor modeling, and they a lot of times I say, oh, well, we just hired you know, ten PhDs that are going to build these factor models, and you know, I thought, well, I've been doing this a long time, and would you ever hire someone, you know, right out of business school who's going to run a a long you know, strategy that's

fundamentally based. But on the quantitative side, the belief was that you could just hire a bunch of math whizzes and you'd be really, really successful. So I remember walking out of these meetings going, this is crazy. You know, I have been watching factors for a very very over twenty years. I've been watching factors. My knowledge is no different than the knowledge you get from following company on a fundamental side. And so I think what happened is

a lot of a lot of these big institutions. They really fail at factor timing because you know, there is you know, as we like to say it frames our viewpoint. We are not a black box. And I know certain things about what happens. For instance, I know that momentum tends to fizzle out in the second half of December, right because people are done tax loss harvesting and they they they poured into the winners, and you know, momentum

kind of reverses in the late December. So you know, that's just that's this knowledge of So we do run factor timing models. I can tell you that, yes, we're talking about the global concentratet, but we run a strategy that just looks at our factor timing model, and it's an enhanced index, and it's been running for a long time. It's done very very well with a much lower tracking

error that's attracted kind of enhanced index product. So our factor model models have added value from it, and therefore timing has worked, but it hasn't done as well as our more concentrated strategy like global contract simply because there is value to fundamental research.

necessarily mean they're you know, gross stocks. They could be very defensive consumer staples type stocks. One of the reasons why I still believe we're in the early stages or you know, kind of you know, kind of not real early, but we're we're not the tail end of this bull market is yes, consumer state, peoples and healthcare stocks have underperformed, but there are a lot of stocks that are perceived as very earning stable that are still very very expensive

because they the investors perceived downside risk. So earning stability is not necessarily just you know, tech growth. Another one would be dividend yield, right, high dividend yield, It can be a quality metric well, that tends to work in bear markets. So you know, certainly tech is not our gross stocks are not necessarily high dividend yields. So I

think there's different ways to dissect the quality factor. We look at in terms of profitability as one, so that does capture those gross stocks, but we look at bond proxies as one, so those are higher dividend yields, And we look at earning stability, which is in my opinion, the ultimate risk off factor. That's what works into bear markets.

insurance stocks traded very high multiples. They do not move with money center banks, right, They've done much better than money center bents. They're actually a much more defensive group than money center banks. So yes, on the surface, you'd say, well, we're making a financial bet because we're making a value bet, but be careful that because some of those insurance type stocks they actually fall into the You know that our defensive,

defensive bucket. So I guess when I boil it all down, where we are and you know, obviously having a big financial weight has helped in the last month. But what we're achieving, at least in the US, is an overweight to growth, an overweight to value, and an underweight to defensive. So yes, we own insurance company, which fall into defensive bucket, but we're underweight staples, healthcare and things like that that

also fall in to that as well. And so I think if I think about performance here today, it's come not it's you know, yes, we a great performance here today, but and what And that's come from what we're overweight, but it's also come from the factors that we've been underweight, which are the defensive factors. And it's behavioral. I go back to all this works. Quantitative investing works because of

behavioral investment. There is we know that people sell value into recessions because during recessions people go, oh my god, every bank's going to fail, well, every industrial it's going down the tube, And so they sell value sucks and they run into defensive because they're worried about risk mitigation. Downside. I don't want to lose as much, right, so defensive strategies get very expensive in bear markets, and value and

growth tends to get cheap. And as you come out and people realize, huh, not every bank's going to fail, you know, not every gross stocks going down. The two growth and value outperform. And as a bear market proceeds, people say, I don't want downside protection, I don't want dividend yield, I don't want earning stability. I want to make money, and they jettison defensive strategies and they move

more into growth and value. And this is what we are just on the cusp of because early in bear market, you know, bull market, you know, bull markets are born on pessim. Let's buy a lot of defensive stocks. It grows on skepticism, which is last year in matures on optism. It's the optimism phase where people go, I don't care

about don doowntime protection anymore. And this is you know, I started my career at Morgan Stali in ninety one, and this is exactly what I saw, you know, in ninety seven ninety eight, and I see it happening again. Early in the early nineties. People wanted downside protection, they wanted dividend yields in the late nineties, they had no

interest in dividend. So I just it's a quantitative investing works because of the consistency of human behavior and the you know what I would call, you know, kind of the the the consistent fear to greed behaviors that I see in this business.

stock gives us. So when we look at every stock, we know what exposures are they do they do they move with earnings yield or PE low P? Do they move with growth? Do they move with earning stability? Quality? What? What are we getting if we buy the stock? So even before our fundamental re search, guys and gals start, they always start. They have to show us that because we're making if we add a stock to the portfolio,

we're making a factor adjustment. So first and foremost we start with that, and then we drill down into the stocks. But even before we do that, we look at the Okay, so we're thinking of adding a stock, let's say in the value are well, okay, we start with it has exposure to earning yield? Check the box. Okay, we like that. Well, what's the correlation to the other stocks in the earnings yield low pe bucket? Because we want to have companies that will not increase What I remember why I said

in isually our tracking error. I want to have exposure earnings yield, but I don't want to make a what I call a big bet on something that's outside our you know, quantitative models. So in other words, if I just keep adding banks, I'm making a bank exposure, right, So that then and only then do we call down the list to Okay, now, let's let's look at the following stocks. And so a great example, we added a real estate company recently to the portfolio because we wanted

to increase our value exposure. And we have quite a bit of financials as you mentioned, we have industrials, and we didn't have a uh, you know, a real state a stock that moves with the value exposure, at least in the States.

all the major industries are market cap weighted. You know, you could kind of naively do it equal weighted, which gets you a lot of the way there, or you could do some kind of optimization or I've seen a lot of people do things like have their position size be congruent with you know, how good do they think the investment is, or what their estimation of the alpha of this certain investment is. So, how do you think about position sizing within your portfolio?

Why you know, why they haven't outperformed, why they're losing au M and so I think I think passive strategies are bring are doing what's right for the the industry, which is forcing manages to be truly active twenty stock people say, oh my god, that's really concerted. Yeah, it's really concentrated. We try to control the risk by not having all stocks correlated to a theme. But that's what we're Brian and chieve and certainly the performance over time

has proven so. So I think in terms of relative exposure. You know, if you go to our fact sheet it's to shows I'm required to show our top ten. It looks like you look at top ten. Oh it looks like you got big positions in some tech names, but actually on a relative basis, we have much bigger relative position to value names. So that's you know, that's the first place we saw start in terms of position side size. You know, again, I've been in this business a long time.

I've got a lot of tattoos on my back figuratively that of you know, kind of bad decisions. And I've learned that. You know, we're making educated bets, but we don't know everything, and so therefore I don't I want to make sure if something ha happens, it's not going to take them, you know, kind of the fun And so how does that happen is I got to make sure we don't let the relative weight and anyone stock

get too big. So when the relative weight gets to kind of ten percent of the portfolio, I start to switch a little. But the other way we look at it is in terms of we look at each stock's contribution to risk. And we know that if you know, stocks that are very very big in the index, if we bring those down, that will lower our overall risks of our portfolio. So we it's not a you know, there's not any one kind of magical line we do.

Tram Wind stocks have done extremely well, and we think there's you know, there's a risk of underperformance on a short term basis regardless of what our factor modeling says. And certainly we've been forced to trim some big winners this year, but it's really in terms of relative weights. And again, when it gets over ten percent, I start to get nervous that one stock's going to determine the outcome of the portfolio.

Is that where most of the risk management comes from from your from your side or is there any kind of like I mean, I know you're tactical with the factors and such, but is there any kind of like, you know, tactical overlay. Maybe the market's going down and we sell some futures or go to some cash or something like that. Is there anything like that in the portfolio?

don't think that's being honest. Like, are you a manager that's in the business of competing on a relative basis and an active manager or you a you know, a long short you know, kind of neutral where your return is your relative returns cash. You can't be both, right, And so someone says I don't like you know, I'll go to cash. What they're suggesting to you is I'm going to give you a good relative performance on the upside. I'm not going to lose your money on the downside.

I think that is that's just being that's just not honest. I hope in all the data shows that our downside capture is less than the market and our upside is more you know, since we started the strategy, so it

has worked in terms of how we shift. Now how we do that Again, what I told you before is when I look at say in Europe, right, you know, over the last a decade, it really it's it's screened own safe stocks, own quality stocks, and that means focus on the amount of beta risks you have, right, and so we've been very cautious on stepping into deep value or very low value stocks because they tend to have

higher valuation. So the factor model very much guide how we think in terms of how you know, that's the first you know kind of risk management, uh that we do. And then the other thing that we watch is the correlation of a stock to the factor. Okay, so what there's something called residual volatility. I'm really getting quantity here, but volatility. Residual volatility is kind of the unexplained volatility, which is basically the uh, the volatility that comes from

at the company level. So a biotech company has a lot of residual volatility because you know, they you know, it's not it's not correlated to growth, it's correlated to drug success. Stock goes up, drug failure stock goes down, so that has high residual voltilay. I don't want high

residual volatility. I want stocks that are correlated to their factors, because what I desperately don't want to have happened is where I get the factor right, but something happens fundamentally that I didn't know about, and then stock goes down even though I'm you know, in my quantitative side, guys are dancing say yeah, we got the we got the factors right, oh oh yeah, but this company didn't move in the fact So we watched the changes in the

correlation to the fact there's and that can set off what we call a warning bell that oh my gosh, there's a problem here, because you know, for instance, if and our financials did very well, but we know that value in financials did have done very well last month. If we have a stock in financials that hasn't done well, then we're all over fundamental guys going okay, there's a problem there. There's a problem here, and we need it. So that's that's a big part of the risk management.

And then the other the last part is and we kid we have something called correlation Thursday, where we look at the portfolio and address each relationship of the stocks as the correlations come together, and that will cause turnover if you know position as you mentioned position sizing, if boil boy, you know, we've got a couple of AI stocks and gone through the roof and they are moving

one for one. You know, that's going to cause us from a risk management standpoint, to take down the exposures as well.

if it could last for you know, multiple multiple years. Now, how we do that is is is a little bit more complicated, so it's fun to actually talk about it.