[Note: Tuesday, Nov. 12, at 2:00 p.m. ET, I’ll be sitting down with Alex Piré from Natixis Investment Managers to argue some of this out. If you’re in Boston, you can join us in person at the Natixis ETF Investment Forum (register here) and during a webinar that afternoon (no Boston required), for which you can register here.]
To me, the whole premise of factor investing is that it collects “like” groups of stocks together that share similar characteristics, and that those characteristics will be rewarded by the market in certain ways, based on external factors such as the economic cycle, market conditions and so on.
That sounds easy, but in practice, it leaves investors with a few extremely thorny problems:
- Figuring out which factors perform which way based on those externalities.
- Identifying which externalities you think are dominating the investment narrative for the next period.
- Selecting actual funds that will do what the two, somewhat academic, bullet points above suggest.
As I look across the factor landscape and the macroeconomic and product landscape right now, I have to say, I’m not convinced I see the clear pathway through this maze. Consider what the “factor quilt” has looked like for the last decade:
Source: Seeyond as of 08/31/2019
The above chart (courtesy of Alex Piré at Natixis Investment Managers), shows the relative performance of the MSCI US Low Volatility, Momentum, Small Cap and Value indexes versus the broad MSCI US index since 2004. Obviously, you could do this same chart with a dozen or a hundred factors, and you could get more granular, but I think it already highlights a few points.
- In no case for the last 15 years has the broad market been the leader. This in itself isn’t surprising; it would be a weird market in which every factor underperformed.
- Despite more than a decade of headlines about the return of value investing, it’s been a hard strategy to really get behind.
- Low vol and momentum have been pretty consistently dominant—except for those years like 2016, 2012 and 2009, when they’ve really failed to deliver.
I’d argue that this precise moment in time is even more problematic than most years. Here’s how that 2019 column has played out so far, updated for the recent run off the recent bottom:
Selected Factor Performance, 2019
Source: Bloomberg, 11/5/19
There are really only a few conclusions I can draw here:
Value Still Stinks
The other three factors at work all look awfully similar. Sure, you can see the yellow line of momentum swinging higher and lower than the other two, but honestly, this seems pretty noisy to me.
Whither The Anomaly?
If you only saw this chart, you might be surprised to learn that funds focused on low or minimum volatility haven’t just had an OK year of gathering assets; they’ve had their best year ever.
The largest fund in the segment, the iShares Edge MSCI Min Vol U.S.A. ETF (USMV), has taken in almost $13 billion single-handedly so far in 2019. As a group, they’ve never had a run of inflows like this:
I’d argue that these flows—even if the performance wasn’t there—are actually a natural reaction to uncertainty.
No matter your internal political leanings or whether you’re naturally inclined to be a pessimist or an optimist, it’s inarguable that the current market environment could best be described as “damned if I know!” followed by an exasperated sign and likely a shrugging motion.
Unemployment at all-time lows, but manufacturing taking a hit. Trade wars … but a surprisingly loose Federal Reserve. For every positive narrative, it’s easy to find something pointing in the other direction.
Control What You Can
So what’s the logical reaction to uncertainty? Control what you can. That, I believe, is the reason we’ve seen a whole swath of defensive strategies taking hold in 2019; whether it’s minimum volatility funds, gold, bonds, defined outcome products or simply low-cost, diversified beta.
The so-called low volatility anomaly itself is likely explained more by simple investor behavior than by some sort of animal spirit trapped in a cage that we don’t understand.
I’d posit that low vol strategies work at periods of maximum uncertainty simply because investors seek some level of certainty, and min vol strategies offer, if nothing else, a sense of calm. They become the perfect response to, “I want to stay invested, but … have you seen this?”
Bubble Wrap Trade
In decades past, this kind of risk-off trade is much more likely to have been binary. Investors would have just dumped their mutual funds and sat in cash, riding out the uncertainty window and hoping they got the timing right.
Volatility-based strategies provide a much needed middle ground: a way to stay exposed, like we all know we should be, but with a nice layer of Bubble Wrap around us, keeping us from taking the worst of it should the you-know-what hit the fan.
Still, as much as I can explain some of the behavior, I remain a skeptic. The confluence of momentum and minimum volatility leaves me with a sinking suspicion that there’s more afoot. I mean, I get how you could end up with similar portfolios: The same stocks that are consistently appreciating (the momentum signal) are doing it in a low volatility, straight-line fashion (the low vol signal).
But comparing the portfolios of, say, USMV and the iShares Edge MSCI U.S.A. Momentum Factor ETF (MTUM) show that with the exception of Visa, there’s zero overlap in the top 10 holdings.
And from a sector perspective, they couldn’t be more different (13% tech for USMV, 38% for MTUM).
Going Beyond The Math
So how do we parse a market where the “go-go” portfolio and the “mustn’t be hasty” portfolio produce nearly indistinguishable outcomes? At the risk of oversimplifying, I think the answer is that you have to go beyond the math.
The math might be suggesting factors are similar right now, but the right question is probably, would you rather be overweight tech, or financials for the next year? Because that’s the unintended consequence of the momentum versus min vol debate.
Yes, low or minimum volatility strategies can act as Bubble Wrap for the nervous equity investor. But that doesn’t mean you should use a blindfold too.
[Note: This coming Tuesday, I’ll be sitting down with Alex Piré from Natixis Investment Managers to argue some of this out. If you’re in Boston, you can join us in person at the Natixis ETF Investment Forum (register here) and during a webinar that afternoon (no Boston required), for which you can register here.]
Dave Nadig can be reached at [email protected].