Smart beta exchange traded funds help investors access historically proven factors that have helped drive long-term performance, but over the short-term, specific factors may stand out.
“Quality, momentum, value, size, and minimum volatility have historically been drivers of returns across asset classes,” according to a BlackRock research note. “Because they are driven by different economic rationales, they have tended to outperform at different times. For investors with a shorter time horizon and a reasonable appetite for risk, this cyclicality presents an opportunity to tilt portfolios towards one factor versus another in pursuit of incremental returns.”
Specifically, BlackRock currently holds an overweight outlook on the momentum and low-volatility factors while taking an underweight outlook on quality, size and value factors.
Momentum refers to stocks with strong recent performance that tended to maintain their higher returns. For instance, the iShares MSCI USA Momentum Factor ETF (NYSEArca:MTUM) tracks large- and mid-cap U.S. stocks with relatively high price momentum. The underlying MSCI USA Momentum Index calculates the ratio of each stock’s price returns over the trailing 13 and seven months against volatility over the past three years. Companies are then weighted by their risk-adjusted momentum.
The momentum strategy basically bets that hot movers will continue to rise, so investors would buy high and sell even higher. Investors who want to follow this momentum strategy will be betting on outperforming sectors flying even higher.
“We maintain a firm overweight to Momentum as we continue to see strong relative strength and attractive valuations for the factor,” BlackRock said. “The overweight position is also supported by dispersion levels, which have improved since last month and suggest increasing opportunities for outperformance.”
The minimum volatility factor covers stable stocks that can potentially outperform more volatile stocks on a risk-adjusted basis. For instance, the iShares MSCI USA Minimum Volatility ETF (NYSEArca: USMV) selects stocks based on variances and correlations, along with other risk factors.
The low-volatility factor investments work on the idea that they help cushion against market turns, limiting drawdowns that investors experience while providing upside potential. Consequently, the low- or min-vol strategies may produce better risk-adjusted returns over the long haul, which has been backed by extensive academic research.
“Our view on Minimum Volatility has moderately improved from neutral to a modest overweight,” BlackRock said. “Valuations have improved and our regime model continues to suggest a moderating pace of growth, which is supportive of more defensive factors such as Minimum Volatility.”
For more information on factor-based investments, visit our smart beta category.