Factor ETFs For Diversification Or ‘Diworsification’?

These past several years have not been kind to quantitative-, systematic-based strategies, and the period spanning October 2018 through April 2019 has felt like additional salt thrown onto a festering wound.

This year has seen a strong double-digit advance in stocks recovering from the sell-off in the fourth quarter of 2018. However, this year’s advance has been quite narrow, having been led (once again) by U.S. growth technology stocks (proxied by Nasdaq-100), leaving other sectors, styles, and regions far behind (Figure 1).

Figure 1. US Growth Technology Surges Ahead Of Other Major Market Segments (YTD through April 2019)

Source: Bloomberg

Looking back over the 10-year bull market, investment principles such as risk-based investing (the main premise underlying factor or smart beta) and diversification (whether by geography or sector) could have been thrown out the window in favor of investing in just one style: U.S. equities, and technology growth stocks in particular.

Figure 2 displays the yawning stock performance gap that continues to widen between the U.S. and the rest of the world. If one assumes a 50% allocation to U.S. stocks based on share of worldwide market capitalization, then geographic diversification has cost investors about 3.5% annualized returns over this period versus just holding U.S. stocks.

It’s not diversification as much as “diworsification.”

Figure 2. A Tale of 2 Bull Markets: US vs Non-US Stocks (S&P 500 vs. MSCI ACWI ex-USA Cumulative Performance 2/2009 - 4/2019)

Source: Bloomberg

This relative performance gap doesn’t occur in a vacuum, as U.S. companies have demonstrated superior earnings growth and profitability versus the rest of the world that has warranted a much higher equity market valuation (16.6x forward price/earnings for the S&P 500 versus 13.0x for MSCI ACWI ex-USA) (Figure 3).

Figure 3. The S&P 500 (Green Line) Has Produced Superior Earnings Growth & Profitability vs the Rest of the World (MSCI ACWI ex-USA – White Line) to Warrant a Higher Valuation

Source: Bloomberg

One can argue that much of this “superior” profitability embedded in the S&P 500 has been driven by a narrow group of growth technology stocks, which seem to have built structural advantages to enhance their profitability. Figure 4 shows the valuation (price/book) and profitability (forward return-on-equity) gaps between small cap value stocks (S&P Small Cap Value) versus the Nasdaq-100.

This valuation gap will likely narrow once the profitability gap narrows, which has historically happened in a capitalistic, dynamic economy where competition erodes the economic rents enjoyed by excessively profitably companies.

Figure 4. Small Cap Value Looks Historically Cheap vs ‘Growth’ but Valuation Gap Will Persist as Long as Profitability Gap Persists

Mean Reversion Or New Era?

We’ve been expecting mean reversion (valuation, profitability) for quite some time, yet both gaps have only widened over the past two years, suggesting we may indeed be in a new growth-era style of investing due to the structural advantages that seem to have formed between the growth “haves” versus the value “have-nots.”

Perhaps value investing is dead due to the structural forces favoring forward-looking technology over outdated/backward-looking value.

Scanning 13-F filings reveals that many of these large cap technology growth companies are held in portfolios managed by traditional active management firms that have been able to keep up with the narrow market advances and not necessarily by the top passive index fund providers.

But as this gap continues to stretch, expectations become harder to meet. The value premium is typically earned during those moments when the “pain” of value positioning and the “euphoria” of growth investing is maximized. As technology growth stocks become more crowded, fewer buyers are to be found to bid up prices in the face of higher expectations (vice versa for value stocks should they turn around their underwhelming operations).

Quant Strategies Suffer When Nothing Seems to Work

Quantitative equity strategies have been feeling the brunt of factor underperformance. Investors are throwing in the towel on quant as $25 billion has exited quantitative equity funds since last October, according to eVestment.

AQR, one of the few quant shops to manage retail mutual funds tied to quantitative strategies, has experienced significant outflows amid a prolonged period of underperformance.

Quantitative strategies cover a wide spectrum of strategies from traditional factor-based models (i.e., value, momentum, low volatility, yield, quality) to risk-parity (which tends to suffer when bonds and stocks underperform as they did throughout 2018) and hyper-trading strategies such as high frequency trading. But many are struggling to keep up in a period characterized by Federal Reserve pivots on interest rate policies and social media blasts from the U.S. oval office.

Quant advocates will typically maintain that investors must stay the course following significant periods of factor underperformance. However, according to Research Affiliates, investors may underappreciate the magnitude of such underperformance. They also warn of factor crowdedness due to over-reliance on backtesting.

Factor investing, in its purest form, represents a rules-based approach for capturing a specific anomaly in the market not explained by general market risk. Figure 5 displays the cumulative performance of pure factors going back to the beginning of 2000 through 4/30/2019. Take a closer look at the performance trends in this chart, and you’ll quickly see why much of the quant world is experiencing a lot of pain.

Figure 5. Long-Term Factor Winners Struggling While Long-Term Factor Losers Outperforming

What to notice about these factors:

• U.S. value has outperformed all other factors over this period but gave up a large chunk of this leadership starting around the middle of 2014. Incidentally, many single- and multifactor-based ETFs were launched around this period with significant tilts toward value—perhaps Research Affiliates has a point.
• U.S. small cap (inverse size) and profitability round out the other positive performing factors but pale in comparison to U.S. value. U.S. small cap performance has been flat since 2012, as has profitability, despite the latter’s increased popularity as a means to capture “high quality.”
• I was surprised to see U.S. momentum generating a flat return, but this is due to 1) Bloomberg removing sector biases when calculating pure momentum performance; and 2) the large drawdown following the sharp 2009 market recovery. (Recall that only deep value performed well during the initial recovery).
• One would think U.S. growth would have performed much better, but the lackluster performance could also be due to the removal of sector effects since “growth” style of investing has been largely dominated by technology and consumer discretionary stocks.
• U.S. dividend yield and low volatility underperform over the entire period but have outperformed more recently. These factors tend to perform better during heightened periods of volatility as investors shift to more defensive positions, although these factors also struggled in 2018 during months when interest rates shot up.

Reminder To Realign Risk Appetites With Investment Time Horizons

When will the quant pain stop? Perhaps relief is around the corner. But this is a reminder that risk-based investing requires a proper alignment of risk appetites with investment time horizons.

Factor-based (smart beta) investing is no exception, as it can be viewed as an extension of taking on general market risk (general beta). There can be 10-year periods or longer where factor investing does not outperform market-cap-weighted investing. Factor investing involves risks where the reward of a premium is not etched in stone.

Disclosure: The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. 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 are 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 May 9, 2019 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.