On the recent webcast (available On Demand for CE Credit), Valuations Matter: The Time for Multi-Factor is Now, Andy Pyne, Equity Strategist for PIMCO, warned that future returns are expected to slow from the breakneck pace of yesteryear as the bull rally extends. The U.S. equities and S&P 500, which have been the best performers since the financial downturn, are anticipated to generate lower returns while developed Europe, Australasia and Far East, along with the emerging markets, are projected to quicken their pace after falling behind U.S. markets in recent years.
Despite the slower growth rate ahead, investors will still try to seek out avenues of alpha, but more are growing weary of the underperformance of active managers. For instance, less than 20% of active U.S. large blend funds outperformed their passive counterparts over the past five years and little over 10% of active large blend funds outperformed over the past decade.
Alternatively, investors may look to smart beta strategies that combine the best of actively managed styles in a low-cost, passive index-based ETF wrapper. For instance, Rob Arnott, Chairman and CEO of Research Affiliates, pointed to the Research Affiliates Fundamental Index approach of smart beta strategies that specifically targets time-tested factor exposures.
Choosing which factors to incorporate in a diversified portfolio matters, Arnott said, especially given varying valuations and potentially heightened prices of specific factors in the current market environment. For example, the low-beta and high profitability factors are currently trading at elevated valuations.
Consequently, given the risks of potential underperformance in a single factor strategy, investors may consider multi-factor ETFs that could offer greater diversification. Pyne pointed to multi-factor strategies that could provide exposure to multiple factors like value, quality, momentum, low volatility and size to increase diversification and potentially lower tracking error compared to broad market indices.
“RAFI Dynamic Multi-Factor is a smart beta equity strategy that seeks to offer diversified factor exposure through allocations to value, quality, low volatility, momentum and size,” Arnott said, adding that the combined factors could provide a smoother ride when compared to single factors and allocates between factors through a dynamic weighting process.
The value factor would rank stocks by the ratio of fundamental weight to cap weight. The quality factor would rank stocks by high profitability and low investment. The low volatility factor would weight stocks by low systematic risk or beta. The momentum factor would rank stocks by multiple measures of price momentum. Lastly, the portfolio may also include a size component to focus on companies with a smaller size.
The RAFI process also includes selecting components based on fundamental measures of firm size, which include adjusted sales or company sales averaged over the past five years multiplied by the ratio of average equity average assets, cash flow or operating cash flow averaged over the past five years, dividends plus buybacks or the average dividends paid and share buybacks over the past five years, and book value or the most recent fiscal year end reported book value.
The dynamic factor weighting component is seen as an additional layer of return potential, switching between value and momentum indicators. Specifically, the portfolio would lean toward factors that are cheap compared to historical norms and have positive price momentum. The momentum indicator also helps the portfolio from investing in a cheap factor too early.
To gain exposure to this RAFI dynamic multi-factor strategy, investors can look to the PIMCO RAFI Dynamic Multi-Factor U.S. Equity ETF (NYSEArca: MFUS), PIMCO RAFI Dynamic Multi-Factor International Equity ETF (NYSEArca: MFDX) and PIMCO RAFI Dynamic Multi-Factor Emerging Markets Equity ETF (NYSEArca: MFEM).
Financial advisors who are interested in learning more about multi-factor, smart beta strategies can watch the webcast here on demand.