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 is by Corey Hoffstein, co-founder and chief investment strategist of Boston-based Newfound Research.
In recent years, factor investing has come into vogue as a better mousetrap than traditional stock picking. Proponents of factor investing argue that instead of focusing on picking individual securities, investing in an index weighted toward a specific factor can more consistently harvest the associated premium.
Numerous studies on empirical asset pricing have shown that there are many characteristics that can deliver superior risk-adjusted returns, including value, size, momentum, quality, low volatility and high yield. In their five-factor model, Eugene Fama and Kenneth French identify four nonmarket factors: value, size, investment and profitability.
For long-only investors, factors come in the format of tilts. For example, a long-only value-factor portfolio will hold exposure to cheap securities, or a long-only size- factor portfolio will hold exposure to small companies.
While each of the most popular factors differs in definition and the theories for why it might exist, they all share a similar, promising allure: excess risk-adjusted returns.
But these excess risk-adjusted returns are not constant. Consider a value-tilt portfolio over the last 20 years. It has, on an annualized basis, outperformed the S&P 500 by 2.3% a year. Investors, however, do not experience “average,” and the yearly ride value took investors on was quite a roller coaster.
Long-Term Premiums & Volatility
It is important to point out that for the long-term premiums to exist in these factors, they must be volatile over time. The excess return generated by one investor is at the detriment of another.
If the returns were not time-varying, they would be viewed as “free.” In that case, there would be significant money inflow into the style, driving up prices and valuations and driving down forward expected returns until the premium converged to zero.
Quite simply, volatility in the premium itself causes weak hands to fold, passing the premium to the strong hands that remain.
This volatility, however, means that factors can go through significant and prolonged relative drawdowns:
|Annualized Premium||Relative Max Drawdown||Max Drawdown Length|
|Minimum Volatility||0.63%||-21.86%||13 years|
|Dividend Growth||2.45%||-29.52%||6 years|
In defense of the minimum volatility tilt, there is no expectation for it to outperform the market on a total return basis. Rather, it is expected to outperform on a risk-adjusted basis.
However, since most individual investors exhibit severe aversion to the use of leverage, I believe it is worth the comparison on a total return basis.
Weak Hands Fold Easily
So as easy as it is to say a factor tilt will be a strategic allocation, the variation of the premiums that lead to significant, gut-wrenching relative drawdowns can make it hard to actually maintain the strategic allocation.
Worse, factors can actually magnify absolute drawdowns as well. In effect, we’re taking the market and layering on top another return source. While the expectation of that return source is additive, so is the volatility.
Let’s consider the value tilt again. While the annualized excess return was estimated to be approximately 2.31%, the volatility of that premium over the past 20 years was 13.3%. So by taking a value tilt, we’re adding an extra 2.3% to our expected return, but also bringing in a new source of volatility.
Volatility Can Makes Losses Worse
Sometimes that volatility may diversify against market returns—but other times it may compound to make them worse. For example, while the S&P 500 was down -36.8% in 2008, the value tilted portfolio was down -47.8%.
So, over the 20-year period, a value tilt would have added 2.31% per year to your returns. To put that in dollar terms, $100,000 invested in 1995 would have been worth an extra $248,821 at the end of 2016 if invested in a value-tilt portfolio instead of the S&P 500.
Along the way, however, you would have gone through a six-year period of trailing the market by up to -33.85% and seen nearly half your wealth wiped out in 2008. Needless to say, it would have been hard not to “fold” in those scenarios.
Factor Diversification Works
Here’s the good news: diversification still works. An equal-weight portfolio of all five factor tilts, rebalanced annually, would have generated an annualized premium of 2.34% a year with a maximum relative drawdown of only -16.05% (though the drawdown length was still seven years; the late 1990s were a “funny” time).
For investors looking to build a diversified portfolio, all the component pieces are available—value: the Guggenheim S&P 500 Pure Value (RPV | A-63); size: the Guggenheim S&P 500 Equal Weight (RSP | A-78); momentum: the iShares MSCI USA Momentum Factor (MTUM | A-71); dividend growth: the ProShares S&P 500 Dividend Aristocrats (NOBL | A-71); minimum volatility: the iShares MSCI USA Minimum Volatility (USMV | A-76); and even quality: the iShares MSCI USA Quality Factor (QUAL | A-84). For those looking to buy a more turnkey solution, there is the new multifactor fund, the Global X Scientific Beta US (SCIU).
The important takeaway here is that while factor investing can help an investor outperform over the long run, an individual factor can underperform significantly for a prolonged period of time, testing the mettle of any investor.
However, to reap their benefits, we have to consider these exposures as long-term allocations, not trades we expect to benefit from in the short run.
At the time of writing, Newfound Research held positions in RPV, RPS, USMV, MTUM and NOBL. Newfound Research LLC is a Boston-based quantitative asset management firm focused on rules-based, outcome-oriented investment strategies. Newfound specializes in tactical asset allocation and risk management solutions. Founded in August 2008, Newfound offers a full suite of tactical ETF managed portfolios covering global equity, U.S. small-cap equity, multi-asset income, fixed-income and liquid alternative asset classes. For more information about Newfound Research LLC, call us at 617-531-9773, visit us at www.thinknewfound.com or email us at [email protected]. For a list of relevant disclosures, click here.