The rise of smart beta exchange-traded funds (ETFs) has been one of the biggest trends in the finance world over the past few years. Most of them focus on a single factor—such as value or volatility—in their quest to provide investors with a strategy tilted toward a certain style.
When that particular style is leading the market, a portfolio skewed toward securities with certain characteristics can outperform broad benchmarks with ease. However, the opposite is also true: when a factor is out of favor it can result in underperformance if a portfolio is too heavily weighted to that characteristic.
This is the crux of the problem with smart beta ETF investing. While it can arguably be a strategic improvement for a portfolio, it is also a bit of a gamble that a given factor will remain in favor with markets and lead to consistent outperformance. Since there is no telling when a particular factor will see its moment in the spotlight, or for how long, a strategy that focuses on just a single factor might not be enough to provide optimal returns over a full cycle.
A better way?
A more comprehensive approach might be the answer. By taking a number of factors—instead of just isolating a single one—and combining the best-ranked securities into a single blended portfolio, investors may be able to reduce volatility and smooth overall returns. Since the various factors may have uncorrelated returns, combining them may help investors achieve solid outcomes no matter the market environment.
This is best demonstrated by considering the correlation of excess returns between five key factors: value, volatility, quality, size, and momentum for the Russell 1000 Index. Since factor-focused indexes launched for these five factors in the fall of 2015 until the end of the first quarter of 2018, investors have witnessed the following correlations:
Besides size and value, not a single factor correlation is higher than 40%. Instead, most are posting negative correlations including a significant divergence between value on one hand, and then quality and momentum on the other. Furthermore, there are also cases where returns are almost entirely uncorrelated, such as for momentum and volatility where the correlation of excess returns is just 11%.
Global phenomenon
These trends of uncorrelated excess returns extend beyond large-cap U.S. markets. In fact, both ex-US and emerging markets have extremely uncorrelated excess returns, further underscoring the importance of employing a variety of factors from a global perspective.
For developed markets, only quality and volatility have historically shown a return correlation in excess of 50%, while value has shown a negative correlation with three of the other four factors. Meanwhile, size and value have demonstrated a particularly uncorrelated profile—just 17%– while volatility and value can often move in opposite directions, as evidenced by their -71% excess return correlation.
As for emerging markets, negative correlation for excess returns is widely spread when comparing the same five factors. Momentum didn’t have a positive excess return correlation with any of the other four factors, while value had a negative reading with three. Positive correlations did not exceed 25% here, showing just how important a diversified factor approach can be in emerging markets in particular.
Bottom Line
Focusing on a single factor may be a viable strategy for investors in today’s market environment, particularly thanks to the wide range of ETFs that can offer cheap and easy exposure to a given investing style. This was a breakthrough when it first hit the market, as it allowed for tactical exposure beyond general benchmark investments based on a preferred factor.
However, investors should know the limitations of focusing on just a single factor or characteristic. It is too reliant on stability in a fickle market, and while it can outperform a broader approach, it may also result in added volatility or concentration that can increase the overall risk.
That’s why it may be better to consider taking a more well-rounded approach to factor-based investing. We suggest a more diversified strategy to navigate more types of market environments and potentially lower overall volatility. This style may not be as popular as single factor investing, but it may potentially offer a better long-term investing experience, which should be the goal of using factors in the first place.