By Grant Engelbart, CLS Investments
Factors are powerful tools for managing risk and producing excess returns – a pretty consistent message across the financial blogosphere. However, after reviewing the data, it seems investors are underperforming. So, what gives? There are likely many reasons for investor underperformance, but I want to highlight a few that I think pertain to investors – both sophisticated and unsophisticated – who utilize factors. How do I know these mistakes can lead to underperformance? I’ve made them myself!
Ignore Valuations
Like any asset class or style, factors trade in ranges of relative valuations. This has been disputed in recent years, but evidence points to a healthy emphasis – or at least awareness – of the valuation level of factors relative to their histories.
An analysis of the MSCI USA Index “Big 5” factors, which we generally look at, illustrates this point. Simply using price-to-book as a valuation metric (we recommend a composite of several) relative to the parent index, we can determine what factors are trading above or below their historical ranges. One-year forward returns of factors trading below their historical relative price-to-book ratios are shown in the top row below, and those trading above their histories are shown on the bottom.
Several important observations can be made from this simple analysis. First, factors are powerful! Forward returns in both periods are generally stronger than the parent MSCI USA Index. Valuations can be used to take full advantage of this power. Momentum is a high-turnover factor, but I find it interesting that forward returns using valuations as a guidepost are strong for momentum. This may point to the adaptation of the momentum index into value-oriented stocks and sectors at certain times, intersecting those two factors.
Chase Performance
Investors lose more often than not because of performance chasing. We have all seen the behavior gap, and many have attempted to quantify it. We can use historical returns to gauge future outperformance in factors. However, as more and more ETFs are brought to market and become the vehicle of choice for factor-based investing, I suspect we will see more evidence of performance chasing and its impact on future returns.
For an investor who believes in factors but doesn’t wish to make any tactical decisions amongst them, holding an equally-weighted basket of factor ETFs is a good idea, so that’s what we will use to gauge performance versus a performance chaser. Historically, if factors on average outperform for any duration from one month to one year, they tend to outperform the following (rolling) year. As we extend that window further, future outperformance starts to fade before it no longer holds.
As mentioned, it will be interesting as more live data is compiled on the effects of performance chasing in factor ETFs. Depending on the strategy, we’ve seen several back tests underperform once live. One can suspect that investors will bail on that underperformance at the wrong times, as usual.
Forget About Correlations
The simple, equal-weighted, strategic-factor buyer has a lot going for him or her. The excess performance of each of the aforementioned five factors tends to be loosely correlated, with size and value having the strongest correlation. No wonder so many multi-factor products are hitting the marketplace, as it makes a ton of sense to mix and match low-correlated factors together to smooth out the overall ride.
Now the tactical-factor buyer may be tempted to go all-in on a specific factor that is, perhaps, exhibiting attractive valuations and strong momentum. He or she would be wise to, at a minimum, pair that exposure with an uncorrelated factor. Take the recent run in value as an example. Value came alive in 2016 and has since faded somewhat this year (at least domestically). Two of the best performing factors this year, quality and momentum, pair nicely with value due to negative correlations.
Factor investing will continue to evolve with the smart beta ETF landscape. Arming investors with these tools will likely lead to more incidents of investors shooting themselves in the foot. But, effectively managing factor allocations and exposures has a strong place in investment management, and the ETF strategist world is well-equipped to regain some lost ground in recent years.
Grant Engelbart is a Portfolio Manager at CLS Investments, a participant in the ETF Strategist Channel.
Disclosure Information
Investing involves risk. There is no guarantee that investment in any program or strategy discussed herein will be profitable or will not incur loss. Past performance is not a guide to future performance. 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. 2620-CLS-6/2/2017