By Joe Smith, CFA – CLS Investments Senior Market Strategist
Are You Trying to Time Your Factor ETFs?
The ability to time or rotate between a set of investment strategies can help investment managers add value for clients seeking actively managed solutions. Traditionally, many investors have accomplished this through an investment process focused on rotating between sectors, countries, and broad investment styles.
Today, as more and more investors have continued to adopt smart beta ETFs that emphasize a given set of equity risk factors, the number of investors claiming to have the magic formula to rotate effectively between these strategies has increased. Many view valuations as the foundation of what investors should consider when determining which factor ETFs to invest in. They are important, but for most investors, valuations are just one piece of a bigger puzzle to factor investing.
Factor ETFs Have a Wide Range of Cycle Lengths
Factors move in and out of favor just like any investment strategy over the course of a full market cycle. The past few years have shown that quality, momentum, and minimum volatility have all provided some opportunity to outperform a representative equity benchmark, while value and size have both lagged.
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Source: MSCI. Rolling 12-month excess returns for MSCI ACWI Factor Indices vs. MSCI All Country World Index. As of 8/31/2016.
So, how can one measure the typical length of a cycle for a factor? Given the slow-reverting nature of factors in general, they can often be analyzed with clever statistical techniques normally used to better understand properties of signals and wave lengths. The emphasis of this analysis is to find the lowest frequency that has the greatest magnitude in explaining the peak of a factor cycle. For our purposes, we define this as the fewest months where the magnitude is greater than 3% (or as close to it as possible).
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Sources: MSCI, CLS Investments. Spectral analysis done using rolling 12-month excess returns for MSCI ACWI Factor Indexes relative to MSCI All Country World Index.
The number of months it takes a factor versus the market to come full circle in performance can vary quite considerably. Value and size take a very long time to come full circle on average. On the other hand, minimum volatility can cycle much quicker, while momentum, quality, and dividend yield have more medium-term cycles.
But, what good is simply knowing the length of each factor’s cycle when it comes to timing? That information can be valuable when combining it with what’s currently known about the factor’s persistence in performance, which can determine the likelihood of the factor’s trend reversing or effectively reverting.
Determining the Odds for Mean Reversion in Factor ETFs
Imagine standing at a bus stop waiting for the bus to arrive. If the schedule indicates that a bus arrives at your stop every 10 minutes or so, what is the probability of the bus arriving within the next eight minutes? In statistics, these types of questions are usually answered using an exponential distribution. What’s nice about this statistical tool is it provides a useful way to assign a probability associated with events that happen at certain frequencies — in our case the frequency of mean reversion for a factor.
Based on current trends and what we know about the average lengths of factors’ cycles, we can infer some interesting insights.
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Source: MSCI, CLS Investments. MSCI ACWI Factor Indices. As of 8/31/2016
For example, minimum volatility has outperformed the MSCI ACWI on a rolling 12-month basis for the last 22 months; that is nearly double the amount of time it is typically in or out of favor. This would suggest its statistical odds of seeing a reversion from current trends are fairly high. Similarly, value has underperformed on a rolling 12-month basis for the last 24 months; that is nearly the same amount of time associated with its cycle before mean reversion occurs. The statistical odds for this mean reversion are not as high as they are for minimum volatility, but they move higher the longer this trend persists.
Timing Factor ETFs is a Game of Patience
So, what is the key takeaway here? Timing factor ETFs is not as quick-paced or action-packed as most investors would like to believe. Why? Factor-based strategies tend to hone in on one or more factors with behavioral components that cause persistence for an extended period of time. As a result, they exhibit cycles with mean reversion tendencies that may be longer than most investors will wait to play out. Current trends in some factors suggest increased odds for mean reversion at some point down the road. However, as with all things in life, investors should remember that when it comes to factor investing, anything is possible.
This information is prepared for general information only. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. All opinions expressed herein are subject to change without notice. The graphs and charts contained in this work are for informational purposes only. No graph or chart should be regarded as a guide to investing. 2434-CLS-9/21/2016.