This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Benjamin Lavine, chief investment officer for 3D Asset Management.
A lot has been said about the strong market performance in 2017, but not much has been said about the impact of the wide U.S. sector dispersion on U.S. smart-beta performance.
When most equity strategies return north of 20%, one doesn’t necessarily quibble about dispersion or relative performance amongst like-minded strategies. But it’s important to understand how a smart-beta ETF is constructed and how it fits within the overall portfolio.
Smart-beta ETFs that deliver single-factor exposure—such as value and momentum—will generally deliver similar results to each other, as the underlying factor volatility will drive the overall volatility of the ETF over the long run.
However, differences in basket design and security weightings can produce material short-term dispersion among similar strategies, which further amplifies the importance of understanding how these ETFs fit within your overall portfolio from a risk contribution standpoint.
In the past, we’ve highlighted key differences within the low-volatility smart-beta ETF category using the iShares MSCI USA Min Vol USA (USMV) and the PowerShares S&P 500 Low Volatility Portfolio (SPLV) as two primary examples.
The former delivers a low-volatility portfolio via risk-based optimization, while the latter delivers a portfolio of low-volatility stocks via ranking and weighting the lowest-volatility stocks within the S&P 500. Over the long run, such differences should smooth out, but they can lead to short-term dispersion.
In 2017, technology stocks dominated all the other S&P sectors (Figure 1). Sector positioning around technology can explain a large portion of the outperformance active managers enjoyed last year, especially large value managers versus a market-cap-weighted style benchmark like the Russell 1000 Value Index. This high level of sector dispersion was a main contributor to the dispersion seen among smart-beta ETFs that provide exposures to the same factor theme.
Figure 1: Technology Sector Dominated All Other Sectors In 2017
To Neutralize Or Not To Neutralize Sectors?
In factor construction, one determines whether or not to “neutralize” sector effects. This can be done at the ranking stage, where stocks are ranked within their respective sectors, or at the portfolio construction phase, where sectors are assigned their market-cap weighting; larger sectors receive larger overall weightings.
In 2017, sector neutralization largely determined how your smart-beta ETF performed and whether it delivered the desired factor exposure you were expecting.
A momentum smart-beta ETF that didn’t “sector neutralize” probably performed well above momentum ETFs that incorporated some form of sector neutralization (Figure 2).
For instance, the MSCI Momentum Index methodology, which underlies the iShares Edge MSCI USA Momentum Factor ETF (MTUM), does not apply sector neutralization when constructing the factor index, although it does take into account the security’s market capitalization in the final index weighting, which can help temper the overall sector exposures.
Figure 2: 2017 Calendar Year Returns Of Representative Single-Factor Momentum ETFs vs. S&P 500 ETF (SPY)
However, some smart-beta ETFs perform sector neutralization so as to minimize the risk contribution from sector over/underweighting versus a market-cap-weighted benchmark like the S&P 500. Figure 3 displays the technology weightings of representative momentum smart-beta ETFs. Although it is not a one-to-one relationship, better-performing momentum ETFs generally had higher technology weightings.
Figure 3: Latest Reported Technology % Weighting Of Representative Single-Factor Momentum ETFs vs. S&P 500 ETF (SPY)
For value-based smart-beta ETFs, the opposite happened: Value-based ETFs that “sector neutralized” generally outperformed those that didn’t (e.g., the Russell 1000 Value Index).
(Figure 4 displays the 2017 calendar-year returns of representative single-factor value-based ETFs versus the S&P 500 ETF Trust (SPY). Figure 5 displays the technology sector weighting.)
Figure 4: 2017 Calendar Year Returns of Representative Single Factor Value ETFs vs. S&P 500 ETF (SPY)
Figure 5: Latest Reported Technology % Weighting of Representative Single-Factor Value ETFs vs S&P 500 ETF (SPY)
What 2017 Teaches Us About Smart-Beta ETF Dispersion
Over time, the differences associated with sector neutralization should wash out, as one would expect the underlying factor variance to explain most of the overall ETF variance. However, 2017 highlights how wide and lopsided sector dispersion can lead to smart-beta ETF dispersion.
So, what is the right approach when constructing smart-beta ETFs?
If you look under the hood of most tactical sector rotation strategies, they’re generally incorporating some form of momentum or trend-following signals. Rarely will you see them incorporate valuation-based signals. That is because momentum, rather than valuation, tends to be a better predictor of forward relative returns.
Factor purists would argue that one should invest in the factor itself, regardless of the resulting sector or ancillary risk exposures. You take the bad with the good, because it all helps explain the historical factor behavior. It’s when you start introducing neutralization and optimization techniques to stamp out the “unwanted” external factor sources that you lose the purity of the underlying factor.
Regardless, the sector dispersion of 2017 highlights the importance of knowing what you’re investing in.
Sector neutralization might make sense if you hold a portfolio with few positions and you desire the underlying sector exposures to reflect the broader market. Non-neutralization might make sense if you are targeting purer factor exposures, or if you want to offset the sector bets taken in other parts of the portfolio. It comes down to portfolio construction and how the smart-beta ETF fits within your overall portfolio.
At the time of this writing, 3D Asset Management held positions in USMV, SPLV, VTV, and MTUM. The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate; however, 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above is all inclusive or complete. Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC, and the reader is reminded that all investments contain risk. The opinions offered above are as of Feb. 6, 2018, and are subject to change as influencing factors change. More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2, which is available upon request by calling (860) 291-1998, option 2, or emailing [email protected] or visiting 3D’s website at www.3dadvisor.com.