By John Lunt, President of Lunt Capital Management, Inc.
The Morningstar ETF Conference was the center of the ETF Universe in early September. The conference highlighted ETF industry growth and impressive sophistication of ETF products and solutions. At the conference, I had the opportunity to participate on a panel titled “Getting Active with Factors.” Our moderator, Alex Bryan from Morningstar, did a masterful job stimulating thoughtful discussion about the Smart Beta ETF landscape and about the characteristics of popular factor strategies. I was privileged to join Anthony Davidow from Charles Schwab, Thomas Martin from GLOBALT, and Rob Nestor from BlackRock iShares. Each panelist brought a unique perspective to the discussion, and I gained several valuable insights from listening to my fellow panelists.
The terms “Smart Beta” or “Alternative Beta” are commonly used but not necessarily commonly understood. When investors refer to “Market Beta,” we simply understand it to reference the market capitalization-weighted return or exposure of a particular asset class. Therefore, “Smart” or “Alternative” Beta simply includes any index methodology or weighting strategy that is different from a market-capitalization approach. The term “Smart Beta” is unfair, as it implies a market-cap beta is “dumb.” Instead, we frame the discussion as pure market exposure (as represented by a market cap weighting approach) and the introduction of strategy exposure (as represented by a set of rules that include, exclude, or weight the asset class components differently than their market weight). In our opinion, many Smart Beta strategies are thoughtful and warrant consideration. However, investors need to recognize that Smart Beta does not eliminate all types of risk. Instead, the risk has simply changed form from market risk to strategy risk.
Many indexes and ETFs with a factor focus are powerful tools that allow investors to express specific views. Academic and industry research points to the potential benefits of factors such as value, low volatility, high quality, and momentum (the definitions and combination of factors are varied and extensive). We embrace the growing library of research that argues for the use of factors within investor portfolios. Importantly, we recognize each factor will have seasons of outperformance and seasons of underperformance relative to each other and relative to the market-cap weighted benchmark. The potential for differences in performance and for high tracking error are desirable—this opens the potential for outperformance. Factors go in and out of season, and in our view, these transitions provide tremendous opportunity for factor rotation.
At Lunt Capital, we are less focused on the sustainability of outperformance for specific factors than we are excited about the large dispersion of performance across factors within a specific asset class. Dispersion is necessary to justify tactical risk. For example, the U.S. Large Cap Momentum factor often looks and behaves differently than the U.S. Large Cap Low Volatility Factor. Both factors have merit, but even long-term outperformance includes seasons of underperformance. Both could be held in a strategic allocation that attempts to capture long-term factor outperformance. Additionally, a tactical strategy could be applied to rotate between Momentum or Low Volatility in an attempt to capture whichever of the two factors seems to be “in season.”
We believe there is virtue in creating allocations dedicated to single factors or combinations of factors. However, we also recognize tremendous opportunity in applying strategies that rotate to the factor that seems to be “in season.” Factor rotation introduces tactical risk/opportunity in addition to the underlying factor risk/opportunity. We believe thoughtful diversification includes both asset class and strategy diversification. Just as investors have embraced the factors represented by Smart or Alternative Beta, we believe they will embrace the next ETF evolution represented by factor rotation or Tactical Beta. (I recognize the term “Tactical Beta” is an oxymoron, but it represents a concept we have long talked about at Lunt Capital, which is attempting to create alpha through the tactical management of asset classes, sector, and factor betas). At Lunt Capital, we also use the terms “Adaptive Beta” or “Dynamic Factors” to highlight the importance of rotating or adapting to the factor or asset class beta that is “in season.”
It is valuable to understand the characteristics of Market Beta, Smart Beta, and Tactical Beta. Each offers attributes that may be useful and important as part of overall portfolio construction. Investors should consider diversifying their Beta. As we collectively attempt to capture opportunities and to manage risks, we can’t ignore one of the emerging themes in the ETF industry— “Tactical Beta” or the importance of “Getting Active with Factors.”