In the past year, I’ve explored a variety of topics related to strategic-beta exchange-traded products, factors, “smart” beta—whatever you’d like to call it. My goal in doing so has been to educate all of you. I hope that the information and insights I’ve shared will help you to make better decisions when it comes to using this ilk of funds in your portfolios, or has otherwise led you to conclude that they simply are not your cup of tea.
In this article, I am going to revisit the topic of factors’ cyclicality. The year was marked by some dramatic changes in factor leadership. Value made a comeback, while growth lagged. Small-cap stocks had been steadily gaining ground on large caps through much of the year and spiked higher in the weeks following the U.S. election. Low-volatility stocks, which had been outperforming the market at large as well as more-volatile names, are now getting left in high-beta stocks’ dust.
To be clear, this sort of reshuffling is a regular feature of not just factors, but sectors, asset classes—you name it. The lessons to be learned from these perpetual games of leapfrog are essential. Implementing those lessons is hard.
Reminder: Factors Are Cyclical
Exhibit 1 is the periodic table of factor returns, in which I use various strategic-beta ETFs as factor proxies. It is immediately apparent that a regular scramble is the norm. I call these factor proxies, as it is important to remember that there is typically a yawning gap be-tween the performance of factors as derived in academia and the investable versions of those same factors represented by these funds. Nonetheless, these funds are some of your best options for harnessing these factors in your portfolio.
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1 MTUM incepted on Apr. 16, 2013. The data presented for periods prior to 2014 in Exhibit 1 and all periods in Exhibit 2 corresponds to the performance of the fund’s benchmark, the MSCI USA Minimum Volatility Index, and thus does not take into account fees or other sources of tracking difference.
2 USMV incepted on Oct. 18, 2011. The data presented for periods prior to 2012 in Exhibit 1 and all periods in Exhibit 2 corresponds to the performance of the fund’s benchmark, the MSCI USA Minimum Volatility Index, and thus does not take into account fees or other sources of tracking difference.
Exhibit 2 provides a longer look at the behavior of these funds over the past nine-plus years (for the sake of consistency, I’ve stopped a month shy of including a full 10 years’ data). There are a number of important reminders in this data. First, while over multidecade time horizons each of the factors represented by these funds has been shown to produce excess returns relative to the market at large, each can lag the market for long stretches. This is evidenced by the fact that dividend-oriented strategies and value have lagged the broad market over the near decade-long period in question. Second, those excess returns have a cost. That cost can be measured in greater relative drawdowns and overall volatility—as was the case for three of the five funds that outperformed the Vanguard Total Stock Market ETF (VTI) during this period. Why does this matter? Because, as my colleague and Morningstar FundInvestor editor Russ Kinnel has documented over the years, more-volatile funds tend to be used poorly by investors. Capitalizing on these factors requires that you be on the platform, ticket in hand, when the value, size, dividend train arrives at the station. These factors have tried many investors’ patience, which is coincidentally part of why they exist to begin with. Hanging on requires discipline.
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In part 2 of this article, we will take a look at the common themes in factors.
