Smart beta or alternative index-based exchange traded funds that track time-tested factors may help investors better control their investment outcomes and achieve improved risk-adjusted returns over time.
“There’s a wide range of possible ways to incorporate factors into an investment strategy,” according to an OppenheimerFunds research note. “An investor may want to target a combination of factors, such as a cyclical factor and a more defensive factor. Another investor may use a factor to complement existing portfolio holdings, or look to off-the-shelf, multi-factor portfolios…. However investors decide to use them, factors offer a low-cost way to exert a degree of control over the fulfillment of their objectives.”
To start off, the six most widely observed factors, including value, quality, size, low volatility, momentum and yield, have exhibited a history of delivering improved returns over time with lower volatility. Between June 2001 and September 2017, the Sharpe Ratio of the Russell 1000 was 0.45, whereas the the six factors offered better Sharpe Ratios than the index.
“Among them, Momentum delivered the weakest return per unit of risk at 0.48 – still an improvement over the index – while Quality’s Sharpe Ratio came in at 0.58, driven by both better returns and lower risk. Interestingly, the Size factor had the most robust performance for the quarter, but also the highest standard deviation. On the flip side, Volatility had the lowest standard deviation along with the lowest up capture, but also the second lowest down capture,” according to OppenheimerFunds.
The varying levels of improved risk-adjusted returns as represented by the Sharpe Ratio reveals that while the factors are helpful, there is still uneven levels of potential returns offered by the individual factors. The difference in returns is particularly noticeable over short-term time frames.
“Factors may experience periods of material outperformance or underperformance relative to their own history and the market because the macroeconomic backdrop plays an important role in influencing performance. For example, the Value factor outperformed in 2013 and 2016, but underperformed in 2014, 2015 and 2017,” OppenheimerFunds said.
However, the varying levels of performances also means that factors exhibit low to modest levels of correlation to one another, with the average correlation of the pairs is only 0.06%. Consequently, when combined, the a multi-factor portfolio could improve diversification and diminish volatility.