After trailing market, factor ETFs may shine in a low-return environment

“I expect more clients to start considering factors, including ones that don’t have an active allocation,” said Antonio Picca, head of factor-based strategies at Pennsylvania-based Vanguard Quantitative Equity Group, speaking at Inside ETFs in Florida last week.

“Our 10-year economic outlook for U.S. equities is in the mid-single digits. Factors come up in a lot of conversations with advisors who are looking for clients to achieve, say, a 4% spending objective in this low-return environment.”

Fellow panellist Craig Lazzara, managing director and global head of index investment strategy with New York-based S&P Dow Jones Indices, said that today’s factor indexes aim to give investors “access to the same return patterns that active managers generate in a way that’s cheap, transparent and easy to understand.”

Panellist Kamal Bhatia, president and CEO at Iowa-based Principal Funds, argued that investing using factors is “newer and better” than investing by sector because factors hold true across multiple sectors and asset classes. He gave the example of a risk-off investor who chooses to invest in utilities to become more defensive. Doing so, however, risks including utilities stocks with high volatility.

“There’s better engineering to approach that problem,” Bhatia said. “You can approach it from a low-volatility lens and actually get a better outcome.”

With all the information now available to investors, does the systematic mispricing that factors aim to capture still exist in today’s markets?

“As long as the markets are about people, there will be behavioural biases,” Picca said. “I believe factors are driven by a combination of risk drivers and behavioural biases.”

Picca gave the example of the liquidity factor, which involves investing in relatively illiquid stocks. Since liquidity tends to decline during market downturns, investors who have the stomach to stay invested during such periods “can be on the other side of the trade, provide a service to the rest of the market participants and earn a premium,” he said.

He also noted investors have been dumping value stocks due to the factor’s underperformance over the last decade, thereby locking in losses. Yet Vanguard research predicts that pending innovation will cause value to return. Investors’ lack of patience is evidence of another behavioural bias, Picca said.

Benefits of multifactor investing

Panellists generally agreed that multifactor investing is better than single-factor investing.

“If you have a confident single-factor outlook and you can get relatively pure implementation, you can get a bigger bang,” said panellist Ted Lucas, head of investment strategies and solutions for Pennsylvania-based Hartford Funds.

“But for advisors who are looking to provide risk reduction, excess returns and more persistence [across market cycles], the multifactor premise might make sense.”

Speaking at a different Inside ETFs session, Brian Kraus, product specialist and director, Investment Consulting Group, Hartford Funds, noted that sourcing exposure to the low-volatility factor in a vacuum can lead to unintentional positive or negative exposure to other factors.

One way to avoid that, Kraus said, is to invest in multifactor ETFs that seek to balance offensive and defensive factor exposure.

According to Connecticut-based FactSet Research Systems Inc., the U.S. market boasts 731 factor ETFs, accounting for 31% of the exchange-traded product universe. Multifactor ETFs comprise the largest share, followed by size-factor ETFs.

Due diligence required

In preparation for Inside ETFs, panel moderator Elizabeth Kashner, director of ETF research at FactSet, conducted an analysis showing that factor funds underperformed their “dumb beta” counterparts by 2.74% annually over the last five years. The underperformance held or worsened when controlling for risk-adjusted returns.

“It’s not a surprise that factors have trailed the market,” Picca responded. “Frankly, you don’t need [to use] factors to outperform in this environment. The market has been carried by a few mega caps.”

He noted that investing solely in mega caps does not outperform consistently over time, and that “factors will give you a nice diversification.”

Lazzara agreed that the “failure of the small-cap effect” over the last five years has led to factor underperformance.

“Typically in factor indices, the weighting is much closer to equal weighting than cap weighting, [so] most factor indices have small-cap bias relative to their benchmarks,” Lazzara explained.

Kashner’s analysis also found that many ETFs with similar names do not perform similarly. For example, two U.S. total market momentum ETFs had one-year returns that were 10% apart.

Given these issues, Lucas stressed the importance of understanding a factor ETF’s characteristics and expected behaviour.

“Design choices matter,” Lucas said. “Implementations that can sound the same are different.”

He gave a laundry list of characteristics to look at, including the starting universe, the signals being used and their weights, the timeframe for a given factor (e.g., 12-month instead of six-month momentum), the residual exposures to sectors and geography, and rebalancing frequency.

“Understand the process and then actually look at exposures,” Lucas said.