Factor Palooza

The world of factor funds continues to expand, covering all sorts of ground or it may be more accurate to say they've proliferated over a period of years and my interest level in learning about them has increased. Either way?

A factor fund essentially takes a standard benchmark index like the S&P 500, a market cap weighted (MCW) index and either rearranges the constituent holdings or selects a portion based on some sort of common attribute like all the companies that start with L. M, N or O, a jokey example. 

A high level observation that I made at least ten years ago about these when the field was much smaller is that there can be no single factor that can always outperform including MCW. If these are all guaranteed to have periods where they underperform then I think it is vital to stay with a factor for at least the duration of a full stock market cycle like someone would do with MCW. Bailing because some random factor lagged for six months increases the odds of chasing the thing that just did well, only to buy it before it lags.

Most of the factors I've looked at are reasonably close to MCW but not all of them. In trying learn about these, I think the comparison to MCW makes the most sense. That's the likely default, an investor not wanting to spend a ton of time is very likely to buy a plain vanilla MCW index fund and maybe rebalance every so often. That's absolutely valid of course even if a stock market blog's readership would probably want a little more engagement than that. 

Here's a reasonably wide swath of factors going back five years.

Five years seems like a reasonable period to look back but shoot, that may not be enough, you can draw your own conclusion on that. 

From left to right, the chart has MCW, minimum volatility, growth, value, equal weighting, growth at a reasonable price, dividends, buybacks and covered calls. There are others like earnings weighted, revenue weighted, other option strategies and the night time effect that we've looked at before, no doubt there are others.

For five years, 5 of the funds lagged MCW and 4 have outperformed, two of the outperformers did so by a very slim margin. The covered call fund is the only serious outlier IMO, the one that just does not look like the others. If you build the same chart on Yahoo Finance and play around with different time periods and slide back in time you'll see that just about all the funds take turns being the best performer and the worst. 

The buyback factor is interesting and quite visible in dark maroon/purple on my chart. In my AdvisorShares side gig days, they had a buyback ETF and it was going through long run of outperforming most other factors, especially MCW. It's middle of the pack now but you can find plenty of periods where it outperforms. 

Value is a tough one. It had a long stretch of underperformance coming into 2022. In 2020, value lagged MCW by 17 percentage points and lagged growth by 33%. Value lagged by a lot less in 2021 but still lagged. This year of course, value is ahead of MCW by 11% and growth by 21%. Is value, an old school factor from before the time the term factor existed, back? I have no idea. A diversified portfolio that goes narrow than one or two index funds should have some exposure to value whether that's from individual stocks or thematic ETFs. 

The GARP ETF, which is SPGP on my chart, has done well versus MCW more often than not. The dividend ETF, SCHD spends plenty of time at the top and bottom of the channel. Growth seems to have spent most of its time above MCW but only the top performer for a short time. Momentum is another one with a lot of time at the top of the channel and a lot of time at the bottom. Covered call is probably a proxy for something else. It might be able to play a valid role in the right circumstance but not as something, IMO, that should generally track the equity market. 

One fascinating observation from the chart. I set it at one year and then moved back in time slowly for 10 years. MCW was never the worst performing factor. It got close a couple of times but never the worst. That is telling in terms of not wanting to be too clever with this sort of thing. 

There's at least a few ways to use factor funds. All in, which I bet some folks do with dividends and maybe minimum volatility products. Some sort of optimization process to blend two or three or four of them together (maybe I can explore this in a subsequent post) in pursuit of something more robust than simple MCW. Picking one to complement MCW. Lastly, there is a potential tactical use here that could be difficult to pull off but where things like dividends and value might be better bear market holds and things like small cap and high volatility might be better coming off the bottom an active rotation could be worth trying for people who are aggressive. The problem with that last use of them is while small cap for example has done better off the bottom quite a few times, there's no reason it couldn't fail the next time. 

Interesting stuff, I think this is worth spending more time on. I have no interest or intention of buying any of the funds mentioned personally or for clients.