Back in May 2019, we penned an article looking at the challenging landscape for factor-based (aka smart beta) investing, “Factor ETFs For Diversification or ‘Diworsification?”. We received a few chuckles for that title, but factor underperformance has become no laughing matter.
Investor flows into passive funds have now exceeded those into active funds, Bloomberg reported, and smart beta may fall victim alongside traditional actively managed funds as simple market cap weighting continues to trounce alternative weightings.
At the time of our May article, we said that time-tested “investment principles such as risk-based investing … and diversification … could have been thrown out the window in favor of investing in just one style: U.S. equities, and technology growth stocks in particular.” We noted that quant funds were already seeing an exodus of investment accounts.
Despite the recent post-August recovery in value and small cap styles of investing, as well as calls for further recovery in value-driven styles by prominent quantitative investors such as Cliff Asness, 2019 could in some ways become the year when smart beta investing died.
Too Dramatic, Or On To Something?
Now, obviously we’re being melodramatic as traditional factor-based investing will still have its institutional and retail adherents, but investors may increasingly tire of factor performance whipsaw, most notably this past September when ‘momentum’ experienced a significant draw-down (a magnitude not observed since the August 2007 quant meltdown).
Consider Figure 1, below. It displays the 2019 year-to-date performance of the Bloomberg U.S. Pure Factors, which represent theoretical long-short baskets designed to capture the specified factors. A net positive return implies the factor is outperforming, and vice versa.
We circled two notable periods that saw significant factor reversal, resulting in two large drawdowns for momentum. Momentum initially underperformed out of the gate in January, which saw a classic January effect wherein value and small cap outperformed, while low volatility, dividend yield and quality (profitability) underperformed.
Figure 1: It’s Been a Struggle for Smart Beta Performance So Far in 2019
(For a larger view, click on the image above)
This year’s January effect reversed itself in February, when we saw significant outperformance of the low volatility/high quality trade, while value and small caps suffered. During this period, momentum picked up the low volatility effect (more like a caffeinated effect) as the trailing 12- to 18-month period included low vol’s outperformance in the fourth quarter of 2018 and second quarter of 2019.
Following the August “Volmageddon,” which saw a crescendo of low vol outperformance, September saw a violent reversal, as if momentum traders tried to unwind their position all at once (and if you leveraged, you were trying to beat the others to the exit).
Granted, low volatility and growth factors are clinging to year-to-date gains, but these factors have not historically produced positive returns (Figure 2).
Most quants may embed a low volatility factor or screen to their factor models, but we doubt few embed a pure growth factor (the closest they may come is either momentum or profitability/high quality).
Figure 2: Historical Backtesting Wouldn’t Necessarily Have Led One to Build a Quant Model Emphasizing ‘Growth’ & ‘Low Volatility’
(For a larger view, click on the image above)
Factor Churning Vs. Steadily Higher S&P 500
Momentum’s outperformance through August may have made up for the underperformance of the other factors, but the September drawdown and subsequent underperformance of momentum is likely producing a bigger hole to dig out of.
All this factor churning is happening as the S&P 500 reaches new highs with 20%+ total returns so far this year. And the performance gap between factors and market cap will only widen, as the oscillation in factor performance is producing a return drag where underperformance needs to be made up with even greater outperformance (the sequence-of-return risk where volatility compounds both gains and losses).
One can characterize 2018-2019 as a unique period for factor behavior, dominated by Trump tweets, U.S./China trade conflict and Brexit uncertainty. But if factors continue to lag the broader markets, then many smart beta investors (especially the newer ones) will likely throw in the towel and fully embrace market-cap-weighted indexing.
Perhaps 2019 will shake out the “weak hands” Corey Hoffstein wrote about back in February 2016, and it will restore the “premium” in smart beta investing.
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