Why Factors Are Cyclical

On Jan. 23, Mo Haghbin, head of product for OppenheimerFunds’ Beta Solutions business, took the stage at Inside ETFs to discuss the future of factor investing. He sat down recently with Inside ETFs CEO Matt Hougan to talk further, digging into the current state of factor investing and the best approach to building a multifactor portfolio.

Matt Hougan, CEO, Inside ETFs: You came to Inside ETFs to speak on a panel called “Beyond the Hype: Strategically Implementing Factor-Based ETFs.” So my question to you is, are factor ETFs and smart-beta ETFs delivering on their promise and actually helping investors?

Mo Haghbin, Head of Product, OppenheimerFunds Beta Solutions (Haghbin): Overall, I think the answer is yes. At its core, smart beta is really built on the foundations of factor investing, which, as you know, has a rich history and very strong academic support.

Many of the flagship strategies have gone through really rigorous testing and have long track records and have delivered superior results, whether in terms of risk reduction or enhanced returns. That includes strategies like value, momentum, low volatility, quality and yield. These are well-established strategies that have been around for a while.

But smart beta as a category is very broad, and there are strategies within smart beta that are not as robust or as time-tested. Investors should take the time to understand the economic rationale behind each strategy and not just focus on the label. In the smart-beta environment, knowing what you own is absolutely critical.
Hougan: Your motto is “challenge the index.” But the index has done brilliantly in the past few years. Why should investors challenge the index?

Haghbin: Most equity indices are built on the premise that weighting securities by market cap is the best approach to accessing the equity market. But what if the company's fundamentals don't align with market capitalization? We know stock prices can deviate from fundamentals based on fluctuating investor sentiment. This can lead to over-concentration in a handful of stocks or sectors that’ve been outperforming recently. We’re seeing that today in major market indexes.

The ad campaign is about challenging that conventional wisdom and getting people to rethink how they’re getting exposure to the market.

Hougan: One of the biggest themes of 2018 is that we’re finally in a rising rate environment. You've recently done a study on stock performance in those environments. What did you find?

Haghbin: There were two main takeaways from that analysis. We found that the companies that tended to outperform were those with smaller market capitalizations and more attractive valuations.

On the other side of the spectrum, lower-volatility stocks, and stocks that paid high dividends, underperformed. Our view is that factors tend to be cyclical, and it's important to understand the overall macroeconomic backdrop when thinking about your allocations.

Hougan: I’m surprised low-volatility stocks did poorly; you’d think they’d do well as people gravitate away from risk and toward quality stocks.

Haghbin: Lower-volatility stocks have historically tended to behave more like bonds. For a variety of reasons, they’ve been much more sensitive to interest rate risks. As a result, they have the potential to underperform cyclically oriented factors like size and value in a rising rate environment.

You have to think about the broader environment. If we’re in a rising rate environment, that means the Fed is increasing rates because the economy is strengthening, which means business activity is picking up and we're moving into a global expansionary environment. That tends to be more favorable for smaller companies and value stocks that are more dependent on that growth.

Low-volatility strategies still offer an attractive risk-adjusted return over a long time period. But for a rising rate environment, you may want more cyclically oriented factor exposures.

Hougan: You’ve launched a series of multifactor ETFs that are built from a bottom-up perspective. That decision lies at the center of a big debate on the best approach to building factor ETFs. Can you talk about why you chose the bottom-up approach?

Haghbin: As with anything else, there are pros and cons to a bottom-up approach versus a top-down approach to factors.

In a bottom-up approach, you’re selecting securities on the basis of how each stock scores across a number of targeted factors. For a security to get a large weight, it would need to score well, not just on one factor such as value, but across multiple targeted factors. It's kind of like a pentathlon, where the overall winner isn't necessarily the athlete that's good at one thing like swimming or running, but rather, an athlete that’s good at all five events.

In contrast, a top-down approach would create a simple combination of the highest-scoring stocks based on individual factor exposures. That approach is much easier to implement, but it critically ignores the interaction between factors at the single-stock level.

You might have a stock that does well on low volatility but poorly on value, and that would counteract a stock that does well on value but has higher volatility. You can end up with mixed exposure and factor dilution at the portfolio level. That’s why we chose the bottom-up approach.

Hougan: Factors are hard to understand for professionals. How are advisors supposed to choose between competing multifactor ETFs?

Haghbin: There are several key dimensions to consider when evaluating a multifactor ETF, or really, when evaluating any ETF.

Some of them are very product-specific: What is the portfolio construction process, what are the historical risks and returns, what is the tax efficiency, how much does the ETF cost, etc. But I think it's also important to evaluate the ETF sponsor and the index provider.

In traditional passive funds, costs are really the major driver, because the objective of those funds is to give you the market return minus the fee. In smart beta, cost isn't the only factor you have to think about. It makes it a little bit harder, but the effort is worth it, because there are a lot of great products out there that give investors flexibility and the tools to build better portfolios.