Making Sense Out Of Variety
What does make sense is to find a fund that fits a goal you have for your portfolio, whether it’s more small-cap or some value exposure. I hope to give readers a lay of the land for some of the more important products.
- Momentum – invests more in stocks that have been rising in price over the past six and 12 months.
- Value – invests in the cheaper companies in the index as determined by familiar metrics such as book value or cash flow levels. This is probably the most familiar factor to investors.
- Growth – while this looks at forecasting increasing growth, it also looks at companies that have high price-to-book values. As such, it can usefully be thought of as a complement to value-tilted funds. It has the same beta but the opposite exposure to value stocks. Both growth and value funds have had very low alpha (returns independent of the broad stock market) compared with the other funds.
- Quality – While intuitive to market participants, this factor has only recently become more academically acceptable as it has been embraced by the grandfathers of factor investing, Eugene Fama and Kenneth French. As an example, quality indexes select stocks with low debt-to-equity ratios or high return on equity. The stocks selected by a quality screen tend to be skewed toward large-caps.
The Interesting Case Of Minimum-Volatility Funds
The volatility-minimizing funds have done the best over both the long and short periods we studied.
They have had returns as good or better than the S&P 500, with significantly higher risk-adjusted returns and lower drawdowns during the financial crisis of 2008-2009.
This is actually a bit of a problem for finance types, as what should happen is that higher-volatility stocks are expected to deliver a higher return, at least over a long period of time, to compensate holders for the extra risk.
We see the opposite in reality and, in fact, if you look at longer periods in stocks or if you add other securities like bonds into the mix, you would find the same puzzling pattern of low-volatility stocks beating the market.
Risk Parity Portfolios
This empirical observation—the outperformance of low-volatility stocks—is also what’s behind another recent market trend; namely, risk parity portfolios. For an accessible description of risk parity portfolios, see the article by Cliff Asness, Andrea Frazzini and Lasse Pedersen, “Leverage Aversion and Risk Parity.”
In addition to documenting the phenomenon, Asness and his colleagues suggest a reason it may exist: leverage aversion. Because most investors cannot or will not employ leverage, they often need to make the poor substitute of high-beta stocks.
The leverage-aversion story makes sense to me, but in his very worthwhile book, “Asset Management,” Columbia professor Andrew Ang suggests that leverage aversion may account for why high beta (and hence more volatile) stocks are overpriced, and not why low-volatility stocks are underpriced. Ang also points out that indexing itself can lead to managers being penalized by being overweight low-beta stocks in terms of increased tracking error.
Whatever the source of this pattern of returns, it is longstanding and, to my mind, the most interesting type of the “smart beta” funds.