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Enhancing Portfolio Returns with Smart Strategies
In recent years, factor investing has emerged as a popular investment approach among both institutional and individual investors. This innovative strategy aims to outperform traditional market-capitalization-weighted indices by targeting specific factors that have historically been associated with higher returns. That said, there isn’t one factor that works every time, and the returns can be cyclical.
One of the most accessible ways to implement factor investing is through exchange-traded funds (ETFs), which offer investors a diversified and cost-effective vehicle to access these strategies. In this article, we will explore the world of factor investing ETFs, their benefits, and the factors they target to potentially enhance portfolio returns.
Understanding Factor Investing
Factor investing is based on the idea that certain characteristics, or factors, can explain the risk and return characteristics of securities and factor investing as investment strategy involves selecting stocks based on specific characteristics or factors that have been empirically known to drive stock returns. These factors can include style factors such as value, size, momentum, quality, and low volatility or macroeconomic factors such as economic growth, interest rates, and inflation. By focusing on these factors, investors aim to achieve higher risk-adjusted returns compared to traditional market-capitalization-weighted index investing.
Factor investing has its roots in academic research dating back to the 1960s, but it wasn't until the 1990s that it began to gain popularity among institutional investors. The concept gained even more traction after the publication of a paper in 1992 by academics Eugene Fama and Kenneth French proposed a three-factor model for explaining stock returns. This model was based on the idea that three specific factors - size, value, and market risk - could explain differences in stock returns over time. Their findings showed portfolios of stocks that tilted to include more companies with value and small cap characteristics outperformed the market over the long term. Factor investing strategies have gained significant attention in recent years among investors looking to enhance their portfolio returns. These strategies have become popular as more options have become available to investors through low-cost, ETF products, making this strategy very easy to implement without the need to hire a manager or pick stocks yourself.
Factor Investing ETFs: An Introduction
Factor investing ETFs are designed to capture the performance of specific factors in a systematic and rules-based manner. These ETFs employ transparent and disciplined methodologies to select securities that exhibit the desired factor characteristics. They offer investors the benefits of diversification, liquidity, and lower costs compared to traditional actively managed funds.
Common Factor Investing ETFs:
Value Factor ETFs: These ETFs focus on stocks that are considered undervalued relative to their fundamental measures such as earnings, book value, or cash flow. The goal is to capture the excess returns that can be generated by investing in companies trading at a discount. As appealing as this factor looks to be, value factor should be utilized in combination with another factor to prevent getting caught in value traps or unsatisfactory business models.
Size Factor ETFs: These ETFs target smaller companies with the belief that they have the potential for higher returns compared to larger, more established companies. The size factor aims to capture the "size premium" associated with investing in smaller firms (by market capitalization).
Momentum Factor ETFs: These ETFs seek to benefit from the persistence of price trends by investing in securities that have exhibited strong recent performance. The momentum factor strategy assumes that securities with positive momentum will continue to outperform in the short to medium term. Since trends change often, Momentum strategies with semi-annual adjustment (e.g., MSCI World Momentum) and rebalancing may not update frequently enough to modify the selection of companies. The risk is that such strategies simply miss when a trend reverses. That happened during the dotcom bubble and during the financial crisis in 2007 (took 5 years to recover from drawdown for momentum factor). As a result, market timing is the most difficult problem here.
Quality Factor ETFs: Quality factor ETFs focus on companies with strong financials, stable earnings growth, low debt levels, and high profitability. The goal is to invest in companies with robust fundamentals and reduce exposure to financially weak or distressed companies. Companies with such characteristics are often seen as less risky investment, especially during economic downturns. However, quality comes at a cost, and these companies are more expensive than value stocks.
Low Volatility Factor ETFs: These ETFs target stocks with lower-than-average volatility, aiming to provide downside protection during market downturns. The low volatility factor strategy assumes that less volatile stocks can deliver competitive risk-adjusted returns over the long term. When compared to other criteria, low volatility stocks can outperform during market downturns but underperform during market recovery periods. As for the momentum strategy, market timing is critical for its success.
For more information on factors check out the MSCI factor methodology described here.
Performance of Different Investment Style Factors
Below table shows the yearly performance during decades between 1930 till 2019 for the US market. Out of nine different decades, small-cap value generated highest return during five decades, clearly beating the S&P500 return.
LT Gov Bnd: Longterm Government Bonds
SCV: Small Cap Value
SCB: Small Cap Blend
SCV: Small Cap Value
S&P500: Large-Cap Blend
LCV: Large Cap Value
4-Fund Combo: equally weighted combination of large-cap blend, large-cap value, small-cap blend, small-cap value
1-mo T-Bill: 1 month treasury bills
However, based on US market data for the last 40 years, momentum and quality factor have best performed compared to the MSCI USA index, while value and low volatility could not keep up with the main index.
For the MSCI World Index, quality factor has shown an outperformance of 2.9%-age points versus the main index (10.0%) over the period of 10 years.
How do style factors perform over a longer investment horizon? According to performance data of all major style factors provided by MSCI index company for the period June 2008 till 2023, the parent MSCI World index was significantly outperformed by World Quality, while World Value was underperforming (245%). Since June 2008, the MSCI World Quality index has achieved a gross return of 463% to June 2023, compared to the parent index's "only" 308%. World Momentum and World Small Cap could generate only insignificant outperformance compared to the MSCI World.
For the broader MSCI All-Country World Index (MSCI ACWI), which is covering emerging markets in addition to the MSCI World Index, the picture is similar and the difference between the best performing factor quality and the main index even higher (12.3 vs. 9.3% over 10 years period).
One essential consideration is how long it will take for a factor to recover from drawdowns. If a factor shows significant volatility, it is not necessarily a bad sign; but if your investment cannot recover quickly enough from drawdowns, that's really bad.
The Ulcer Index can provide insight into how long it takes for an investment to reach its highs again after a drawdown. The higher the index number, the longer the recovery phase will take and the worse it will be for your investment.
Another way of taking advantage of factor investing is by blending factors styles to smooth out factor-driven cycles. So called multi-factor investing combines, for example, value with quality or quality with momentum factor.
Benefits of Factor Investing ETFs
Diversification: Factor investing ETFs offer investors exposure to a specific factor across a diversified portfolio of securities. This diversification helps reduce risk and can enhance risk-adjusted returns. By diversifying across multiple factors, investors can reduce their exposure to any one particular factor and improve their overall portfolio diversification. This can also lead to reduced volatility.
Cost Efficiency: Factor investing ETFs typically have lower expense ratios compared to actively managed funds, making them a cost-effective investment option for accessing specific factors.
Transparency: Factor investing ETFs disclose their methodologies and holdings, allowing investors to understand the underlying factors and how the ETF is constructed. This transparency helps investors evaluate the ETF's effectiveness in targeting the desired factor.
Accessibility: ETFs are traded on stock exchanges, providing investors with easy access to factor investing strategies. They can be bought and sold throughout the trading day at market prices.
Systematic Approach: Factor investing provides a systematic and rules-based approach to investment decision-making. Instead of relying on subjective judgment or qualitative analysis, factors offer a more objective framework for selecting securities. This systematic approach can help reduce behavioral biases and emotional decision-making, leading to more disciplined investment strategies.
Considerations for Investors
While factor investing ETFs offer potential benefits, it's important for investors to consider a few key factors:
Performance and Risk: Factor investing strategies may go through periods of underperformance, and there is no guarantee that historical factor premiums will persist in the future. Investors should assess the performance and risk characteristics of factor ETFs before investing.
Understanding Factor Exposure: Investors should carefully evaluate the specific factor exposures provided by each ETF. Factors may have varying levels of sensitivity to different market conditions, and it's crucial to align factor exposure with investment objectives. Also, frequency of rebalancing performed by the ETF providers may have significant impact on the performance.
Portfolio Construction: Factor investing ETFs can be used as core holdings or as complements to existing portfolios. Investors should consider their overall investment strategy and assess how factor ETFs fit within their portfolio construction.
The table below shows risk behavior, factor correlations, and performance for each business cycle phase (source: MSCI Factor Research).
| Risk Ratio vs. Index | Correlated with | Business Cycle |
Value | similar | Momentum, Quality | procyclical |
Quality | lower | Value, Small Cap, Momentum | defensive |
Size | higher | Low Volatility, Quality | procyclical |
Momentum | similar | Value, Quality | procyclical |
Low Volatility | lower | Value, Momentum | defensive |
Conclusion
Factor investing ETFs have gained significant popularity as investors seek strategies that go beyond traditional market-capitalization-weighted approaches. These ETFs offer exposure to specific factors that have historically demonstrated a potential for outperformance. However, investors should conduct thorough research, consider their investment goals and risk tolerance, and evaluate the specific factors targeted by each ETF before making investment decisions. Factor investing ETFs can be powerful tools to enhance portfolio returns, but they should be used as part of a well-diversified investment strategy. Always study the ETF documentation to understand the exact investment strategy as it matters how a factor strategy is being implemented (e.g., regarding frequency of portfolio rebalancing).
Further Interesting Reading About Factor Investing:
Factor Investing For Dummies (2022): This is the perfect Dummies guide for beginner to seasoned investors who want to explore more consistent outperformance potential. Factor Investing For Dummies can also help portfolio managers, consultants, academics, and students who want to understand more about the science of factor investing.
Factor investing: A stock selection methodology for the European equity market (cell.com) (2021): This paper uses European high capitalization corporate data for the 1991–2019 period to demonstrate that a systematic active management portfolio based on the identification of value, profitability, and momentum factors can outperform competing benchmark strategies.
Bender, Jennifer and Briand, Remy and Melas, Dimitris and Subramanian, Raman Aylur, Foundations of Factor Investing (December 30, 2013): Summary of the six equity risk premia factors Value, Low Size, Low Volatility, High Yield, Quality and Momentum, and which are grounded in academic research and have solid explanations as to why they historically have provided a premium.
Disclaimer: The scenarios or investment products presented above should not be construed as investment advice. All investments involve some level of risk, and past performance is never a guarantee of future returns. As always, do your own research in order to validate and better understand the underlying risks.
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