If you had to label the five figurehead factors of investing for the long term, this is what they would be: low volatility, momentum, quality, value and size. These guys are the Mount Rushmore of so-called factor investing, says John Feyerer, director of equity ETF product strategy for PowerShares by Invesco.
“They offer a premium across long time horizons and across many different market cycles,” he says.
In short, factors are investment styles or themes. Different fund managers will focus on them in their own way. If you put more than one factor together in a fund, utilizing traditional passive indexing and some more higher skilled quantitative investing found on the active side of money management, then you have what is called a “smart beta” fund. ETFs like BlackRock’s iShares and its rival at Invesco are all in on this now, taking some thunder from the active side of the money management business, in hopes to give retail investors cheaper access to quite complex and long-thinking investment strategies that were once the hallmark of active money management only.
Factors are the driver of risk and return. Dan Draper, a managing director for PowerShares, calls factors “the DNA of an investment portfolio.”
For years, active managers have been given higher fees and skill-based accolades basically because of factor exposure. The term factor investing is new, but its academic underpinnings go back decades. In the 1960s you had the capital asset pricing model (CAPM), which is a standard way to pick quality stocks and their associated risks over time. In the 1980s, you had studies done on large cap versus smaller and mid-cap performance, along with a new found focus on value. What’s changing now is the delivery.
We produced Nasdaq’s Smart Beta Symposium on April 19. Each of the three hour long sessions is available for CE credits on demand. During the session, Nasdaq moderators asked investment advisors in attendance whether or not they used factor based ETFs in their client portfolios. Nearly two thirds (70.2%) said no, with 29.8% saying yes. Of the no vote, 22.4% said they were interested in finding out more.
Here’s what we know: over a very long period of time, factor investing really does pay off.
PowerShares took the performance of their Mount Rushmore factors and compared them to the S&P 500 from December 1991 to December 2016 as well as the performance of the MSCI Europe Africa Far East (EAFE) index over a slightly shorter period ending the same time. What they found was that each factor beat on an annualized return basis for both the S&P 500 and the MSCI EAFE, with only value losing out on an annualized risk adjusted return basis in comparison to the S&P. It beat the EAFE.
PowerShares constructed this mock portfolio by building a fund of twenty-percenters. It looks like this: you take the top 20% of the lowest volume stocks on the S&P based on standard deviation over a 12 month period of stock returns and equally weight those constituents. For momentum, you take another 20% of stocks in the index that had the highest 12 month price return as a proxy for momentum and equal weighted them as well. For value, they took another 20% of stocks with the lowest price to book ratios, and so on across the mountain.
Longer periods matter. Five years is no good. One year is terrible.
Over a 12 month period, underperformance was between 17% to 33% under the S&P 500.
“If you just equal weighted these factors, and held them through thick and thin, you would beat the benchmark over ten years,” says Jay Gragnani, head of asset management research at Nasdaq Dorsey Wright.
In 2009 one of the most oversold pieces of junk in the market was the mortgage backed derivatives nightmare known for its call letters AIG. The American International Group. To most in the market, and surely to retail investors in the RIA community, AIG was like the zombified body of the deceased Lehman Brothers and Bear Stearns. It was the worst stock to own in March 2009 and for the months prior to that. But out of the S&P 500 universe, which was the best stock three months off the March 6 bottom? It was AIG.
“The momentum factor has to find that strength before it catches hold in the market,” says Gragnani. That is essentially what these funds try to do. Some build Mount Rushmore funds. More of those are coming to market. Others build cheaper single factor, or dual factor funds.
Dorsey Wright likes low volatility, strong momentum plays. They’ve built indexes to measure that and built ETFs to invest in them.
Their momentum factor ETF, the four-star rated Dorsey Wright DWA Technical Leaders fund (PDP 92,00 -0,58 -0,63%) is up 89% over the last 10 years. But if you bought the PowerShares Nasdaq-100 (QQQ 437,48 +3,56 +0,82%) ETF to simply track the benchmark, you would have killed PDP by about 100 percentage points.
On the other hand, the four-star rated PowerShares S&P 500 Low Volatility fund(SPLV 63,73 +0,03 +0,05%), is up 74% since it launched in 2011, beating the SPDR S&P 500 (SPY 515,71 +2,85 +0,56%), which rose 71%.
Total flows into this type of product since September 2011 have equalled only 16% of all U.S. ETF flow. They account for roughly 12% of total ETF assets under management, according to Bloomberg as of December 2016.
Invesco and Nasdaq both believe ETFs will play a bigger role in factor investing which will, once again, disrupt the investment management industry. The bar is now being raised higher for active money managers.
These are definitely not get-rich-quick strategies.
“With very few exceptions, it’s rare that all of the factors are ever in excess return mode at the same time,” says Cameron Lilja, director of product development at Nasdaq Global Information Services. “The longer historical premium is what matters. You’re probably not going to get the timing right. You’ll need strategic allocation to a number of the factors and be in it for the long haul, too.”