Factoring Expectations

Whenever we've talked about factor funds like momentum, buybacks or maybe something dividend related I usually say something along the lines of if you're going to pick a factor, it is very important that you stick with it for a long time. The odds of getting into a factor that has done well of late only to see it then struggle are high in a Murphy's Law sort of way. But if it is a valid factor, it will have its time in the sun. If there is any value to factor investing it is that it works longer term. Anything else and the result is likely just continually chasing the factor that was hot last year. This behavior will lead to underperforming. 

In selecting a factor other than market cap weighting, I think there needs to be some reasonable basis to believe it will differentiate. For example, based on how it has performed since inception, I don't know why anyone would choose the iShares Quality Factor ETF (QUAL). It looks identical to the S&P 500.

It's not the quality factor itself, it's the fund. There are other quality factor funds that don't track as closely as QUAL. 

I had the above thought about factors as I read this from Jeff Ptak about the difference between fund performance and the return that investors actually get from those funds. The difference or "gap" is not about the funds, it's about investor behavior like buying JEPI after its great 2022 only to sell it at the end of 2023 because it lagged by a mile. You could apply that example to managed futures funds. Jeff looked at several alt categories and the gap varied depending on the fund but other than precious metals funds, investors generally underperformed the funds they held due to poor timing buying and selling. 

The problem isn't the funds, it's investor behavior that causes the issue. For this article, Jeff looked at funds that...

...utilize approaches that aren’t tethered to the broad stock and bond markets. These types of funds boast high diversification potential and thus, in theory, could nicely complement one’s primary stock and bond allocations. But because they’re idiosyncratic, it’s also possible they could push investors’ buttons, nullifying whatever diversification benefits they might confer.

Dialing it in a little more precisely, I think this is about having the wrong expectation. "High diversification potential" means won't look like the stock market. Client/personal holding BTAL is a great example. It is reliably, negatively correlated to the stock market. There's no other reason to buy it other than for that attribute. If it's doing well, chances are everything else is doing poorly. You want BTAL to do poorly but watching it do poorly can lead to giving up right before you might need it again. Managed futures is another example. It can do well when stocks are going up but it goes long stretches of languishing when stocks are going up. Watching managed futures do poorly can lead to giving up right before you might need it again, repeated for emphasis. 

Investors might think they want this;

But it means living through this;

The blue line portfolio will get the job done but it will differentiate which means it will occasionally lag behind a more traditional 60/40 which is a breeding ground for impatience and giving up at exactly the wrong time. 

One nit to pick from Jeff's article is that with the correct expectations, I don't think buying at the wrong time is that big of an issue. Whether you buy something like BTAL when it's up a lot like in April of this year or now when it is down, going forward it is very likely to continue to be negatively correlated to equities. Regardless of when it is bought, if the next 20% for the S&P 500 is up, then BTAL should be expected to drop and if the next 20% for the S&P 500 is down, then I would expect BTAL to go up. 

A week or two ago we looked at the latest autocallable ETF and the performance thus far of the first one. Both are from Calamos with symbols CAIQ and CAIE respectively. A commenter noted that because of what the index underlying CAIE actually tracks, that the fund got much closer to having the distribution suspended. Down 40% and the payouts stop until it gets back above the down 40 mark. I replied that I was probably being sloppy in saying the S&P 500 when the actual index isn't quite the S&P 500, it is the Merqube US Large-Cap Vol Advantage Autocallable Index which is close but not exact. 

Today I took a look and maybe I don't get it yet but I don't think it got anywhere near the point where distributions would be suspended.

Here's the link to the Merqube site if you want to dig in closer. 

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.