[This article appears in our June 2018 issue of ETF Report.]
Factor ETFs have grown in popularity, whether single factor or multifactor. While multifactor funds say they can smooth out the ride, sometimes it’s hard to tell which factor may be contributing (or detracting) from performance.
Looking at some of the best-performing single-factor ETFs for 2017 shows how the factor can sometimes help increase excess returns in markets that are already strong. Several of these funds are non-U.S., which isn’t a complete surprise, since ex-U.S. funds outperformed the broader domestic funds.
Sean Clark, chief investment officer at Clark Capital Management Group, prefers using single-factor ETFs to complement existing holdings over multifactor ETFs.
“What we like about blending the market-cap-weighted ETFs and also the single-factor-based ETFs into our process is we get very unique exposures in the portfolio,” he said. “When a factor is being rewarded in the marketplace and our [investment model] steers us in that direction, we want to be pure to that factor.”
The dividend category for factor funds is vast, with 149 funds listed, although some dividend funds are in fixed income, too. The WisdomTree Japan SmallCap Dividend Fund (DFJ), up 22.3% in 2017, eked out a slightly better performance than its currency-hedged counterpart, the WisdomTree Japan Hedged SmallCap Equity Fund (DXJS) did, at 22.2%.
Joe Tenaglia, asset allocation strategist at WisdomTree, said Japanese ETFs are benefiting from the sustained growth in the Japanese economy for the first time in a while. Japan has seen eight-straight quarters of gross domestic product growth for the first time since the late 1980s as well as expansion in the purchasing manager indexes. “What's changed, though, is the fact that this economic growth is being driven by domestic demand and consumption,” he said.
Most Japanese companies pay a dividend, so to differentiate from the index with DFJ, Tenaglia says they remove the 300 largest dividend-paying stocks, and then weigh them by their dividends, which still leaves over 900 stocks.
“The really big differentiator is the dividend-weighted approach, where we sum all the cash dividends paid out, and then each company gets weighted by their contribution to that total, instead of being weighed by their market cap,” he explained.
Size is the second-biggest factor category, with 118 small-capitalization ETFs trading. Small-cap funds are available in U.S. growth and value, and there are Canadian, European and other developed-market ex-U.S. While some fund issuers don’t necessarily call their small-cap funds “factor funds,” small-cap funds can fall under the classic Fama-French definition under which small-caps outperform large-caps.
In the last trailing year, the best-performing small-cap ETF was the iShares MSCI Germany Small Cap ETF (EWGS), with a return of 37.17%, close to its 2017 return of 33.61%. EWGS not only outperformed its bigger brother, the iShares MSCI Germany ETF (EWG), which was up 12.5% in 2017, but also outperformed in 2015 and 2016. Chris Dhanraj, head of U.S. ETF investment strategy at iShares, says EWGS’ stellar return may have more to do with its sector components than necessarily its size. Dhanraj says EWGS is overweight technology and health care, which are the two-best-performing sectors year-to-date.
Caleb Eplett, vice president for sales and customer success at YCharts, who also focuses on ETFs, says that given Europe’s strong performance overall last year, the size premium likely contributed to the fund’s return. “The fact that this one was investing in small-caps as opposed to the entire German market made a huge impact,” he said, noting the euro’s strong performance probably also gave the fund a boost.
In contrast, Eplett notes that U.S. small-caps underperformed the U.S. broader market.
For the most part, the value factor continues to struggle against the broader market, and has for the past several years as growth is dominating. Of the 55 value funds ETF.com counts, the best-performing ETF over the last 12 months was the Deep Value ETF (DVP), with a total return of 26.60%, and for 2017 alone it was up 27.3%. That far outpaced the SDPR S&P 500 ETF Trust (SPY), whose 2017 return was 14%.
DVP holds 20 undervalued dividend-paying stocks within the S&P 500 Index, and chooses them based on balance sheet strength, earnings and strong free cash flow. Michael Tiedemann, chief executive officer of Tiedemann Wealth Management, conceived of the fund, but it’s managed by S&P and Exchange Concepts.
He says the discipline of only holding 20 names and rebalancing quarterly is likely part of what helps the fund perform well. To avoid value traps, it looks for companies that are still paying a dividend: “They have to be companies that are challenged but not heading toward bankruptcy.”
Eplett says DVP “demonstrates how a more focused approach to factors reduces the overall correlation. Only holding 20 stocks, DVP made a big run in Q4 2017 and has maintained performance,” compared with other value funds with larger holdings.
Given last year’s bull market, momentum factors did well, and in particular, momentum plays in hot sectors did particularly well, showing how this factor rewarded investors. Of the 36 momentum ETFs counted by ETF.com, one of the biggest performers using this factor was the PowerShares DWA Healthcare Momentum Portfolio (PTH), which has a one-year return of 45%.
Nick Kalivas, senior equity product strategist at Invesco, said momentum tends to do well cyclically one to three years after a market bottom, and he counts the current cycle as having started in February 2016. For momentum to work, it needs sustained, stable leadership and a clear set of winners and losers. Last year’s strong earnings and stable growth helped the factor do well, he says.
“I think we're still in that momentum cycle, although I think with more volatility in the market, the ease of the factor’s performance is being challenged,” Kalivas noted.
Health care as a sector did well in 2017, with most health care ETFs up strong, but Eplett says the momentum factor in PTH helped it outperform other popular health care ETFs.
All charts were provided by YCharts and show total return 2017 performance
Low-volatility funds are becoming more popular, but still remain a smaller part of the factor universe, with 27 funds featuring this strategy. One of the best single-factor fund performers in 2017 was the PowerShares S&P Emerging Markets Low Volatility Portfolio (EELV), which was up 17.3%.
This fund looks at including the 200 stocks that had the lowest volatility last year, using a trailing volatility since it rebalances quarterly, Kalivas says. While it’s not an equal-weight fund, it appears to be one, because the index chooses the holdings with the least volatility, he notes.
Although EELV did well last year with the low-volatility stock environment, Kalivas says that when volatility is rising and accelerating is when low volatility tends to shine.
“The rate of change is a more important driver, meaning that when volatility is really accelerating a lot, that's when it's going to shine more than when it's falling a lot, because it tends to lag behind,” he said.