How To Win With Factors

John Rekenthaler wrote an article at Morningstar about smart beta or factor funds or as Morningstar calls them strategic beta funds that looks at the space in a manner that is shortsighted. A spoiler, I'm not making an argument for factor funds really but the article missed an opportunity to talk about them in a constructive manner. Excerpt:

What I overlooked, though, was whether smart-beta investors would choose well. After all, smart-beta funds are a cousin of sector funds, in holding one segment of a marketplace. And sector fund shareholders have fared poorly, owing to their habit of buying high and selling low. They chase performance.

There's a few things to unpack there. Chasing heat, chasing performance is a behavioral issue having nothing to do with how an index is filtered toward specific attributes. We'll get to sectors in a bit, but investors do chase performance at the sector level too as well as individual stocks and any other segment of the capital markets. 

There are quite a few different factors and down below we'll look at momentum, quality, low volatility, buybacks and.....and....market cap weighting. Market cap weighting is a factor like any other factor. It is the most common factor but it is a factor. 

Going back when factor ETFs started to really proliferate I talked about how no single factor could possibly be the best for all times. First a table of the five factors I mentioned above.

Looking back at eight years which is as far back as the newest fund goes, Buybacks (PKW) was the best performer in three individual years, Minimum Volatility (USMV) and Momentum (SPMO) were the best in two years each, Quality (QUAL) was the best in one year and Market Cap Weighted (SPY) wasn't the best performer in any of the eight years. Note that we have usually looked at the iShares Momentum ETF (MTUM) for that factor but it underperforms SPMO at almost every turn so going forward, we'll use SPMO for blogging purposes.

Looking at the entire period, SPMO was the clear winner even before this year. Minimum Volatility offered the smoothest ride which is what is should do. QUAL looks identical somehow to SPY and PKW appears to be much more volatile than SPY.

It is possible to tease out some expectations about when a certain factor might outperform? For example, in a down market value will probably do better than growth as was the case in 2022. Small cap tends to do better earlier cycle than large cap but it has been a while since that has come into play. If you spend the time and find the patterns then trying to allocate around those indicators is probably better than flipping a coin but not that much better. My sense is that these sorts of indicators used to be more reliable than they are now and this is not something I would try to chase. 

Chase is the word the Rekenthaler used in the excerpt above. To the title of this post, if there is a way to win with factor funds, besides market cap weighting, it lies in making an allocation to one or more and then sticking with it save for rebalancing when/if necessary. That's not a very satisfying answer, pick one or pick a combo and stick with it but that's it. And I define winning as riding through with a strategy you can sleep with and then having enough money when you need it. No matter what factor you choose, you are guaranteed to lag the others some portion of the time. Based on the table above, the one factor you could choose, including market cap weighting will lag more often than not. Market cap weighting was never the single best in the period we studied with those funds yet it was the second best overall and would have been just fine if it fared worse than second best overall. 

For anyone wanting to venture out beyond the market cap weighted factor, what should they do? I'm not sure. You could just look at the chart and say momentum but you'd need to be prepared to lag by kind of a lot sometimes and not necessarily when you'd expect to lag. SPMO did very well on relative basis in 2022 thanks to a late year comeback which is surprising. 

Although I haven't found it yet, I do believe there is a way to combine two or maybe three factors to get consistently, not universally, better results. Cliff Asness is a fan combining momentum and carry (not an equity strategy) as powerful solution compared to traditional 60/40. We've looked at that before using AQR Multi-Asset (AQRIX) as proxy for carry which was suggested by Microsoft Copilot. When I asked it again today it spat out the iShares Commodity Carry Strategy ETF (CCRV) which is just one slice of carry. 

The timeframe is short because of CCRV but the results are very interesting. Yes, the volatility does uptick but the improvement in performance is noteworthy and even though it was just one test in 2022, both momentum/carry portfolios appeared to have crisis alpha. 

It's a similar story with sectors. Some have the tendency to be more volatile than the broad index which will usually, not always, be good on the way up and hurt on the way down. 

The chart is kind of difficult to look at but you've got most of the Sector SPDR ETFs there. I left out energy and materials because the demand profiles can sometimes be procyclical and at other times countercyclical making them less reliable in this context. Technology (XLK) is the easiest to see. It pretty reliably goes up more on the way up and down more on the way down. In 2022, XLK was 900 basis points worse than the S&P 500. If you buy XLK or some other tech sector ETF you are adding volatility. XLY shows a very similar, reliable pattern. I cut the chart off at late 2021 because XLY has struggled since that point. Amazon is the largest holding and mostly traded sideways and Tesla, the second largest holding is down 32% since the end of 2021. 

The note with XLY makes the point of needing to know what is under the hood of any ETF you own. XLY is still a client holding. Looking forward, I would expect it to be up more on the way up and down more on the way down. It was down twice what the S&P was in 2022 but up considerably more than the index from when I bought it in 2008. Communications is another that tends to fall into the same groove as tech and discretionary but it has struggled lately because of a couple of large drawdowns in Google. I've had better luck with using an individual name for this sector instead of a sector ETF.

At the other end of the spectrum are Staples (XLP) and Utilities (XLU). They will generally go up less and down less pretty reliably although they are vulnerable to rising interest rates. You can see how they've lagged long term but in 2022, XLP was down 0.83% and XLU was up 1.42%. DON'T BUY STAPLES AND UTILITIES FOR LONG TERM OUTPERFORMANCE. If you want to invest to the sector level, I do, think in terms of expectations and probabilities. Tech is going to do what I said most of the time and occasionally it will miss. Utilities will do what I said most of the time and occasionally it will miss. That description has nothing to do with the heat chasing that Rekenthaler is talking about although of course you can chase heat too. 

That last table goes back almost ten years and is exactly the sort of long term result you'd expect. Tech adds volatility and adds to long term performance. Utilities, reduces volatility and acts as a drag on returns. Guessing what these would do year to year is just that a guess beyond the fact that stocks go up about 72% of the time.

Sorry, but I think Morningstar can do better at explaining this stuff.

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