Factor ETFs For Diversification Or ‘Diworsification’?

May 17, 2019

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

 

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