ETF.com: Let's talk a little bit about multifactor ETFs. There’s a wider understanding among advisors that factors have periods of underperformance. That seems to be one of the selling points of a multifactor fund that rotates factors.
Swedroe: It really depends on how you construct it. You want to add factors that not only have premiums and meet the tests I laid out, you want to add a factor portfolio that also has low-to-negative correlation to the other assets in your portfolio, because that'll add a diversification benefit.
Two of the classic factors having negative correlation are momentum and value. You would expect a negative correlation, because how do you get to be a value stock? You have relatively poor performance and then it drops, and now you've got low prices to some metric, whether it's price-to-book earnings or cash flow, and the value fund starts buying it, but negative momentum would be shorting it.
Now, imagine you've got two funds, because you want exposure to momentum and value, and the stock is dropping into value so your value fund is buying it, and you're paying that value fund an expense ratio. It's engaging in trading costs. And the momentum fund at the very same moment is shorting it. Now you've paid that fund an expense ratio and you've incurred the trading costs, and you've had obviously no impact on the portfolio, except the negative impact of trading costs.
It's much better to incorporate funds that screen for multiple factors. You avoid the trading costs. And you avoid two fees. It’s common sense. That's something most investors unfortunately don't think through.
ETF.com: In terms of an everyday investor—not an institution or someone sophisticated—is smart beta worth wading into? Or would investors be better off maintaining their market index positions?
Swedroe: I would only recommend it to people who are serious students and willing to take the time to invest in learning about the factors, reading books that will give them the strong belief system, the understanding of why they might consider things. If you don't have that, as I said, you're almost certainly doomed to fail.
The second thing is research shows that diversification across factors that have premiums and low correlations have historically resulted in significantly more efficient portfolios. Low correlation dampens the volatility of the overall portfolio.
At my firm, we’ve been using these strategies for 20-plus years now. I believe they’ve greatly reduced the risk for our clients so that they suffered much lower losses in 2002 and 2008 than they would have had with more marketlike portfolios.
The reason is that because the equities they held had much higher expected returns, they could own less equity risk overall and own more safe bonds. When the risk to all risk factors shows up, those safe bonds tend to go up in value.
By adding factors that have premiums and low correlation, and adding more fixed income, historically you ended up with more efficient portfolios. Academic literature shows that factor diversification provides more diversification, better benefits for market directionality and volatility than just focusing on the single factor of beta.
Contact Drew Voros at [email protected]