It’s no secret that October was a bad month for stocks. The S&P 500 Index dropped nearly 7%, including dividends. Granted, the index still had a positive return for the year after the decline, but October wiped out nearly all the gains the index had posted for the year up to then.
Given the increasing popularity of “smart beta” strategies – portfolios tracking an index organized around a factor such as a stock’s valuation, size, dividend payout, price momentum, etc…, we thought it would be a good time to see how various strategies held up during the difficult month. It turns out, value and dividend strategies tended to hold up better than growth and momentum strategies.
For example, using mostly a variety of iShares funds, the iShares Core High Dividned ETF (HDV) was the best fund on our list, clocking a loss of 2.21% for the month. The second-best fund was the iShares Select Dividend ETF (DVY), which posted a 3.9% loss. Every dividend factor ETF that iShrares has outpaced the S&P 500 for the month.
Similarly, all value strategies did relatively well for the month. And the value-over-growth theme was on display in the Russell 1000 returns too. The iShares Russell 1000 Value ETF (IWD) posted a 5.16% loss for the quarter. That was a favorable showing versus the 6.84% loss of the S&P 500 and the 8.91% loss of the iShares Russell 100 Growth ETF (IWF).
Minimum volatility strategies such as the iShrares MSCI Min Vol USA EGTF (USMV), which lost 4.05% for the month, also did relatively well. Minimum volatility strategies were first developed by a professor of finance named Robert Haugen, who didn’t agree with the modern academic finance notion that volatility defined risk. The theory states that higher return must come from higher volatility or, to say the same thing, higher risk stocks. But Haugen thought lower volatility stocks could produce higher returns over long periods of time. A student of Benjamin Graham, Haugen suspected that higher volatility stocks were those Graham called “glamor” stocks that were market darlings for a time, but whose businesses ultimately couldn’t support the lofty prices the market awarded them. Better to own the steadier stocks of steadier businesses that didn’t inspire infatuation – and then great disappointment — in the market, thought Haugen.
Sure enough, those glamor stocks struggled in October. The iShares Russell 1000 Growth ETF (IWF) lost nearly 9% while the iShares Edge MSCI USA Momentum Factor ETF (MTUM) lost nearly 10%. The top holdings of the Russell 1000 Growth Index are Apple, Microsoft, Amazon, Facebook, and Alphabet. Two of those, Microsoft and Amazon, are also top holdings of the momentum fund in addition to Visa, Boeing, and Mastercard.
It’s important to note that I examined a lot of iShares funds, and many of them have a unique way of doing smart beta. Often different factors can emphasize different sectors. For example, a quality sector may emphasize consumer staples and consumer discretionary, while a value factor emphasizes energy, materials and industrials, which generally trade at lower valuation multiples than, say, technology and healthcare. The iShares funds, however, do things a little differently. The quality fund picks the highest quality stocks from each sector. So the fund’s sector distribution is the same as the S&P 500 Index, which wouldn’t be the case if the fund simply chose the stocks that scored the highest on a quality screen. The difference between the fund and the index is simply that the fund emphasizes different stocks in each sector than the index.
In any case, the results from October suggest that investors should be alert to a rotation from more aggressive and inherently richly priced sectors to cheaper ones.
This Long-Short Fund Has A Little “Magic” In It
At the end of March, the institutional share class of famed value investor Joel Greenblatt’s Gotham Index Plus fund (GINDX) passed its three-year mark and garnered a 5-star rating from Morningstar. That means, over its first three years, the long-short stock fund landed in the top-20% of the large blend fund category for its volatility-adjusted return.
Long-short funds have high fees because they pay dividends and margin costs on short positions, and this fund is no exception with an eye-watering 3.61% expense ratio. But it’s a good time to look under this fund’s hood to see if it still deserves a place in some portfolios.
Background on Greenblatt and the “Magic Formula”
As I wrote in a previous article, Joel Greenblatt began his career has a hedge fund manager using a strategy that could be described as special situations. He looked for corporate restructurings including spinoffs and bankruptcies and managed to post a 50% annualized return for a decade, albeit with significant volatility as he tells it. Greenblatt likes to write and teach, including holding a position as an adjunct professor at Columbia Business School, and the book that emerged from that experience became a hedge fund cult classic, You Can Be a Stock Market Genius.
After closing his fund, Greenblatt devised a strategy that could accommodate more assets called the “Magic Formula.” The strategy is really a simple smart beta two-factor model, picking stocks with the best combination of EBIT yield and return on invested capital. Greenblatt ran a backtest and realized picking the stocks that scored best on these two factors at the start of each year would have beaten the index by 4 percentage points annualized over a quarter century. Three books came out of testing this strategy – The Little Book that Beats the Market, The Little Book that Still Beats the Market, and The Big Secret for the Small Investor.
When I was at Morningstar I calculated that the strategy beat the S&P 500 Index, including dividends, by 10 percentage points annualized from 1988 through September of 2009, based on Greenblatt’s back-tested numbers from his first book on the strategy and funds he was running at that time. That doesn’t mean the formula beat the index every single calendar year. In fact, it showed patterns of underperforming for as many as three straight years before recovering and overtaking the index again. Value investors must tolerate fallow periods. In fact, value strategies work over the long run precisely because they don’t work over shorter periods. Everyone piles out when the strategy is faltering, leaving stocks poised for outperformance. The “magic” of the formula is really based on the human psychology or behavior that causes many of us to be bad investors.
Using the Magic Formula to Go Long & Short
Now Greenblatt and his partner Robert Goldstein have based a series of long-short funds on the strategy, which, to varying degrees, own the stocks that score best on his formula and short the stocks that score the worst on it. For each dollar invested, the Gotham Index Plus fund gains 100% exposure to the S&P 500 Index. It also selects long and short positions from the 500-700 larges U.S stocks that are that most expensive or cheapest on Gotham’s assessment of value or the Magic Formula. The resulting portfolio is 190% long and 90% short.
So the fund combines full exposure to the index with active management. Part of the fund tracks the market, and another part of the fund uses a value strategy to own and short stocks. The benefit of having both market exposure and exposure to an active strategy is that investors who still want to beat the market don’t have to withstand such severe fallow periods that every value investor endures and that the fund would likely have if it were just invested in the magic formula strategy.
With such a high expense ratio, however, the fund must outperform significantly when the strategy is working – and not underperform significantly when it’s not. The avoidance of underperformance versus the index is especially true since one of Greenblatt’s objectives is to provide an index-like experience for investors so that they won’t get shaken out when the active strategy is out of favor. That seems like a tall order. Nevertheless, for the 41 months the fund has been in existence it has outperformed the index. Over that period, the fund’s compounded annualized return is 14.54%, while the S&P 500 Index’s return is 12.75%.
Over long periods of time that difference – 1.79 percentage points – adds up to serious returns. For example a $100,000 investment earning 7% for 25 years would grow to around $540,000, while the same investment for the same period of time earning 8.79% would growth to around $820,000,
Interestingly, the Gotham Index Plus fund has a 1.42% Sharpe Ratio for the past 36 months according to Morningstar, while the index has a Sharpe Ratio of 1.55%. This implies that the index has a slightly better volatility adjusted performance. But the Sharpe Ratio views all volatility (up and down) as the same, whereas investors obviously don’t. Indeed, the Sortino Ratio of the fund, which penalizes an investment only for downside volatility, is higher – 3.42% — than the index’s 3.30%. Additionally, the fund has captured 105% of the index’s upside moves and 77% of the downside moves.
So far, despite its breathtaking expense ratio, the Gotham Index Plus fund has delivered on its promise – outstripping the index by a decent amount over a 41-month period, while delivering a roughly similar volatility experience. Investors should consider that other long-short funds must pay dividends and margin costs too. It’s noteworthy though that if the stock market endured a steep decline, the fund would then be paying even higher fees assuming dividends weren’t cut too badly in that event. If the expense ratio on the fund reached, say, nearly 6% instead of nearly 4% now, the fund might do fine, but would it overcome the index as easily? Of course, such a big decline in the stock market itself, although painful in absolute terms, might be a relative boon for the fund as both its long and short magic formula components could outperform the index during a big drop. And stocks would be cheaper after such a decline, arguably favoring the fund’s strategy. But 6% or more seems like a rather high hurdle.
It’s difficult to recommend a fund this expensive. But paying dividends and margin costs is part of shorting. And if you aim to find a mechanical, smart beta-like long-short fund that can beat the market over the longer haul, this fund’s strategy has a decent chance.
30-Stocks To Add Some “Magic” To Your Portfolio
Index giant Vanguard manages more than $5 trillion of capital today, up from $1 trillion in 2010. Vanguard manages assets mostly indexed on a capitalization weighted scale, meaning companies are ranked according to their stock market value. But, while Vanguard and other traditional index providers have grown dramatically, a slew of alternative index funds called “smart beta” has also become popular. These funds rank stocks on metrics such as their underlying businesses’ economic footprint, valuation metrics, price momentum, volatility, and other “factors.”
One of the more interesting smart beta strategies is Joel Greenblatt’s “magic formula,” which is a simple two-factor model. A former hedge fund manager who enjoyed wild success trafficking in special situations like spinoffs and corporate restructurings, Greenblatt published two books called The Little Book that Beats the Market and The Big Secret for the Small Investor detailing a formula that ranks stocks based on their EBIT/Enterprise Value (a modified earnings yield or E/P ratio) and return on invested capital (ROIC). Cheapness is generally what the great value investor Benjamin Graham stood for, and business quality or returns on invested capital is generally what Graham’s most famous student, Warren Buffett, stands for. Combining the two investment touchstones, the strategy simply owns the stocks with the best combination of these two metrics, and swaps them out for whichever ones score best the next year.
When I was at Morningstar I calculated that the strategy beat the S&P 500 Index, including dividends, by 10 percentage points annualized from 1988 through September of 2009, based on Greenblatt’s back-tested numbers from his book and funds he was running at that time. That doesn’t mean the formula beat the index every single calendar year. In fact it showed patterns of underperforming for as many as three straight years before recovering and overtaking the index again. Value investors must tolerate fallow periods.
Greenblatt runs Gotham Capital now, a firm that offers mutual funds that invest in variations of this strategy. Most of the funds are long the stocks that score best on the two metrics and short the stocks that score worst in various proportions. Rather than looking at fund holdings, which are updated every quarter, we thought it would be interesting to run the screen on Greenblatt’s website (www.magicformulainvesting.com), which is more up to date, to see which stocks score the best on the screen. We ran it for the top-30 companies over $5 billion in market capitalization.
We also included current dividend yields, although that’s not part of Greenblatt’s screen. Dividend yields can be misleading when screening for stocks because high yields can be indications that the dividend is about to be cut. They also don’t tell you anything directly about profitability and cheapness, although some analysts make inferences about profitability from them. Nevertheless, we included them anyway to show that if investors use Greenblatt’s screen they can capture a current yield of 2.5%. If you run the screen for smaller capitalization stocks, it’s doubtful that you’ll get such a hefty yield. Greenblatt’s screening website allows you to screen stocks from $1 million to $5 billion in market capitalization.
Incidentally, Morningstar recently ran an article highlighting 10 cheap high-quality stocks with growing yields, and two stocks on the Greenblatt screen made Morningstar’s list for independent reasons – pharmaceutical and healthcare supply companies McKesson (MCK) and AmerisourceBergen (ABC) Morningstar analysts use a discounted cash flow model to analyze stocks, assigning a “moat” or competitive advantage rating, forecasting future cash flows and applying a discount rate to arrive at a present value.
Here’s the Greenblatt list:
Disclosure: Clarity Financial, LLC currently, or is planning to, hold positions in KLAC and CVS.
Building A US Stock Portfolio With Smart Beta Funds
Two articles in the finance press this weekend wondered if value stocks were poised to outperform. In Barron’s, Reshma Kapadia interviewed value managers and recounted how poorly value stocks have done over the past decade. Similarly, in the Wall Street Journal, Jason Zweig noted that value stocks, and the funds dedicated to picking or tracking them, should do better, but cautioned that nobody knows when that will happen. Investors seeking to profit from a value premium likely will require patience.
Indeed for a decade now, growth has outperformed value by more than three percentage points annualized. The Russell 1000 Growth Index has returned nearly 11%, while the Russell 1000 Value Index has returned a little more than 7%.
Ever since the publication of an academic paper in 1992 by Eugene Fama and Kenneth French proclaiming a higher expected return from stocks with value metrics, investors have increasingly assumed that value stocks would outperform growth stocks. Fama and French defined value stocks as those with low price/book value ratios, but the definition has increasingly encompassed stocks with low price/earnings ratios and low price/cash flow ratios. Certain sectors tend to trade with low price/book and price/earnings metrics such as energy, materials, financials, and utilities. Other sectors tend to trade with higher multiples. Those include technology and healthcare. Given the run technology stocks such as Facebook, Amazon, Netflix, and Google have had in recent years, it’s not surprising that growth has done well.
Fama and French thought value stocks returned more because they were more volatile. Risk is volatility, according to modern academic finance, and you get paid – at least eventually – for accepting and tolerating risk. That, of course, begs the question of whether it’s risk if you always get paid. But Fama and French might point to the last decade and say that it can sometimes take a long time, and that’s punishment enough for some investors.
Zweig is correct to say that nobody knows exactly when the trend will turn. However, investors have already waited a long time during which growth stocks have outperformed value stocks. It might be a decent bet to assume that if you can wait another decade, value should return to favor. In other words, it’s not necessary to call the exact turn of the trend if you’ve got a long enough time frame.
Six funds to consider for capturing a value premium are the iShares Russell 1000 Value ETF (IWD), iShares MSCI USA Equal Weighted ETF (EUSA), PowerShares FTSE RAFI US 1000 ETF (PRF), PIMCO RAE Fundamental Index Plus fund (PXTIX), iShares Edge MSCI USA Value Factor ETF (EUSA), and the DoubleLine Shiller Enhanced CAPE fund (DSEEX).
The iShares Russell 1000 Value ETF, which tracks the Russell 1000 Value Index, is the most straightforward approach. This fund has 26% of its portfolio in financials and 9% in technology. That’s a marked difference than the iShares Russell 1000 ETF (IWB), which has 24% in technology and less than 15% in financials. And that kind of sector exposure differential is what you’d expect.
The iShares MSCI USA Equal Weighted fund is another well-known approach to capturing a value premium — or of eliminating the “noise”or high ranking of the most loved stocks associated with capitalization weighted indexing. It simply tracks an index of equally weighted stocks, lowering the weighting of the most loved and elevating the weighting of the least loved. Each stock currently occupies around 0.20% of the portfolio. This approach breaks the link between a stock’s market capitalization and its rank in the index.
Equal weighted indexing isn’t perfect though. It has capacity constraints because the 500th biggest stock in the S&P 500, for example, can only take so many dollars chasing it before its price gets pushed up too high. An approach that still captures the value premium, but doesn’t suffer from the capacity constraints of equal weighting, is the PowerShares RAFI US 1000. This fund tracks the Research Affiliates Fundamental Index, which re-ranks the stocks in the Russell 1000 by sales, book value, cash flow, and dividends.
A fourth option is the PIMCO RAE Fundamental Plus (PXTIX), which gains exposure to a modified RAFI Index through a derivative collateralized by a bond portfolio. This fund has two sources of return – the difference in the return of the bond portfolio compared to the price of the derivative and the performance of the modified index. The index is modified by the managers’ active insights to enhance returns. This fund is better suited to tax-advantaged accounts because of the use of derivatives.
Fifth, the iShares Edge MSCI USA Value Factor fund targets the cheapest stocks within each sector of its “parent” index, the MSCI USA Index. It ranks stocks against their sector peers, and chooses the cheapest ones within each sector, creating an “underlying” index that it tracks. The underlying index, therefore, maintains the sector allocation of the parent index. That means the fund avoids the typical sector overweights that one finds in other value funds. But it also means the fund won’t avoid or underweight expensive sectors. It will only own the cheapest stocks in those sectors. Indeed in the fund’s most recent Summary Prospectus, it warns that “a significant portion of the Underlying Index is represented by securities of information technology companies.”
A Value Fund That Likes Technology?
Finally, investors seeking to break the link between market capitalization and index rank and to capture a value premium should also consider the DoubleLine Shiller Enhanced CAPE Fund – especially if Zweig is correct in arguing there’s no telling when “traditional” value stocks will start to outperform again.
Like the iShares Edge MSCI USA Value Factor fund, the DoubleLine fund also approaches the world by looking at market sectors, but in a different way. It evaluates sectors of the S&P 500 Index by the Shiller PE or “CAPE” (current price relative to the past decade’s worth of real, average earnings). Each sector is judged according to its own historical valuation, and the fund consists of four of the five sectors that rank the cheapest relative to their own histories. After identifying the five cheapest sectors on a CAPE basis, the fund rejects the sector with the worst one-year price momentum among the cheapest, leaving it with exposure to four of the five cheapest sectors.
Like the PIMCO fund, this one gains exposure to stock sectors through a derivative collateralized with a bond portfolio. It also, consequently, has two sources of return.
The unique aspect of this fund is that it doesn’t tend to be consistently heavy in energy, materials, utilities, and financials, which usually enjoy significant representation in value-oriented funds. (Of course, it could be exposed to those sectors, if they were the cheapest on a CAPE basis relative to their own histories and none of them triggered the negative price momentum filter.) Surprisingly, according to its most recently published fact sheet, the fund now has exposure to the technology, healthcare, consumer staples and consumer discretionary sectors, which are often associated with better-than-average growth and profitability. This ought to give those waiting for a more traditional value rebound or those who think technology stocks are uniformly expensive pause.
Investors unable to resolve the mixed signals of traditional value sector underperformance and growth sector cheapness on a CAPE basis can pair the DoubleLine fund with one of the other value funds. This combination allows investors to break the link between market capitalization and rank of stocks in their portfolios, but doesn’t necessarily overweight traditional value sectors and stocks. It helps investors benefit from different approaches to value.
A Day At The Beach, Part 2 — Global Asset Allocation
In this second installment relating my trip to the Research Affiliates Advisor Symposium in Newport Beach, CA, I will discuss the firm’s second major line of research, which involves the appraisal of global asset classes. The firm manages the PIMCO All Asset (PAAIX), and All Asset, All Authority (PAUIX) funds. These are global asset allocation funds that seek the maximum real return, often by emphasizing non-mainstream asset classes. The funds own stocks, bonds, commodities, and currencies through underlying PIMCO funds. Over the long haul, the goal of All Asset is to beat TIPS and inflation by 5 percentage points, while the goal of All Asset, All Authority is to beat the S&P 500 and inflation plus 6.5 percentage points. Research Affiliates thinks these inflation goals are tall orders currently.
For example, a glance at the asset allocation part of the firm’s website shows that U.S. stocks are poised to deliver no return over inflation over the next decade. Stocks from developed countries, by contrast, are expected to deliver a little more than a 4% annualized real return, and those from emerging markets are expected to deliver nearly a 6% annualized real return. Besides emerging markets stocks, no asset class, save private equity, is likely to deliver more than a 5% real return.
First, Chris Brightman, CIO of Research Affiliates, led the attendees through the firm’s asset class returns. Bonds returns, of course, follow starting yields closely throughout history with a correlation of 0.96 between starting yields and future 10-year returns. Similarly, strong correlations exist globally.
In equities future returns follow starting earnings yields, using the inverse of the CAPE Ratio (Price relative to the past decade’s worth of real average earnings). The correlation between starting earnings yields and subsequent 10-year returns is 0.75 since 1926, though admittedly, returns have been higher lately. Again, similar correlations exist in other countries.
The current level of the CAPE implies a roughly 80% overvaluation of stocks. Other metrics, including Market Capitalization relative to GDP, Tobin’s Q, and Hussman’s PE show similar overvaluation. There’s hardly a way to look at US stocks, and not conclude that they are overpriced. Among Western developed countries, only the UK appears as if it is priced to deliver a real return of more than 5% for the next decade.
A Demographic Interlude
During his talk, Brightman speculated on why valuations seem to be higher than in the past. He remarked that macroeconomic volatility is lower today than it’s typically been in an agrarian economy where bad weather can wreak economic destruction. There are arguably lower risks in a post-industrial economy, and perhaps this is properly reflected in lower return prospects. There is also a greater ease in investing with the advent of index funds and ETFs; it’s easier to obtain a more diverse, lower-cost portfolio.
Brightman also made a demographic observation – an increasing percentage of older people in an economy tends to lower productivity growth. This, in turn, has an influence on real rates of return. Brightman used the example of teenagers who consume a lot and produce nothing. But when teenagers get to be, say 25 years old, the rate of change in their productivity from the time they were 15 is extremely high. Similarly, there is a great rate of change in productivity from the ages of 25 to 35. But then there is a lower rate of change from 35 to 45, and after 45 there is no difference in growth. Then, when adults become old, they revert to being teenagers again – consuming a lot, but producing little. The difference is that teenagers have parents and senior citizens have assets – and that’s why asset prices are higher and return prospects lower.
All of this means that the U.S. enjoyed a period of superior growth as the baby boom generation matured and entered the work force. In other words, the post-war demographic trend flattered the superior growth of that period, and without similar demographic trends, the growth likely can’t repeat. It’s possible that stocks can deliver higher returns if earnings-per-share growth increases, but for three or four decades the ratio of profits to GDP has been growing. Brightman was skeptical that corporate profits could continue growth faster than the economy because, if that trend continued, it would likely violate rules of social equity. It’s likely that corporate profits will not grow faster than GDP from this point.
Non-Mainstream, Better Beta, and Rebalancing
Investors have a few options to boost returns. First they can consider non-mainstream stocks and bonds. Emerging markets, as previously mentioned, are poised to deliver higher returns than financial assets from developed countries. In fact, Rob Arnott, in his talk on after-tax returns, volunteered that one-third of his liquid net worth is in emerging markets equities. Second, investors can potentially extract greater returns from low-returning asset classes by using smart beta strategies such as fundamental indices. Capitalization weighted indices can’t deliver excess returns, and active management cannot collectively beat the market. Third, investors can rebalance diligently across asset classes instead of buying and holding, which tends to overweight recent winners. “Tactical over-rebalancings,” as Brightman puts it, can help boost returns.
Brightman’s three recommendations make me think investors need good advisors now as much as ever. Individual investors aren’t always comfortable choosing non-mainstream asset classes. They also aren’t as able to pick smart beta funds as they are plain index funds. Moreover, investors aren’t likely to pick the best smart beta funds, which, as Brightman’s colleague FeiFei Li noted, are not always characterized by the lowest expense ratio. Last, advisors are probably better equipped to accomplish the rebalancing that Brightman thinks will be a significant part of a successful investor’s future returns.
A Day At The Beach, Part 1
I’ve just returned from the Research Affiliates Advisor Symposium in Newport Beach, California last week. If the cloudy and sometimes rainy weather disappointed some of the attendees, the conference itself didn’t. As I reflect on it now, it stands as one of the finest investment conferences I’ve attended. This will be the first in a three-part series on the conference.
The argument against traditional indexing
Before I talk about the conference, a few words about Research Affiliates are in order for readers who aren’t familiar with the firm. Research Affiliates is the company of Robert Arnott who is the author of influential papers on investing and a former board member of the Jounral of Portfolio Management. Arnott arguably devised the first “smart beta” stock strategy which he calls the “fundamental index.” Instead of ranking stocks in an index based on market capitalization, which is how most index funds function, the fundamental index ranks them on four economic factors of the stocks’ underlying businesses – sales, cash flow, dividends and book value. In other words, the fundamental index or “RAFI” (Research Affiliates Fundamental Index) “breaks the link,” as Arnott puts it, between a stock’s rank in an index and its market capitalization or price. In fact, that’s what all smart beta strategies do; they are all based on some newly devised “beta” or index that doesn’t rank stocks based on their price or market capitalization. I like Arnott’s approach because it forces investors to think of stocks as ownership units of businesses and to rank stocks based on characteristics of their underlying businesses.
Products that use the fundamental index include the PowerShares FTSE RAFI US 1000 ETF (PRF) and the PIMCO RAE Fundamental PLUS Fund (PXTIX). Other funds apply fundamental indexing to foreign stock markets. Arnott’s insight that capitalization weighted indexes necessarily give an investor more exposure to more expensive stocks and his research into other forms of index construction started the smart beta revolution. Other “factors” or characteristics of groups of stocks that could help those stocks beat the market – namely small and value — were identified in a famous paper by Eugene Fama and Kenneth French. While Dimensional Fund Advisors took its bearings from the Fama/French research and built funds with capitalization weighted indexes that it tilted toward small-cap and value stocks, nobody created an alternative index or helped create funds that were invested in one until Arnott.
One award-winning academic paper has argued that the fundamental index has a “value bias” making the PowerShares fund’s S&P 500 Index-matching performance over the past decade, when value has underperformed growth, striking. (Arnott also classifies his index as value-oriented on the smart beta portion of the Research Affiliates website.) The PIMCO fund has outperformed the index by more than 300 basis points annualized, but it’s structured differently than the PowerShares fund. The PIMCO fund gains exposure to the fundamental index through a derivative, which it colateralizes with a bond portfolio. So it has two sources of return – the fundamental index and the bond portfolio that PIMCO manages in an effort to overcome the price of the derivative.
Since the development of products using the fundamental index, other funds with other “factors” have hit the market. Along with plain capitalization weighted index funds, smart beta funds have been attracting assets in droves while traditional active managers mostly bleed capital. But there aren’t as many factors that can consistently beat capitalization weighted indices as marketers might have you think. The “factor zoo,” as Research Affiliates calls it, may be well populated, but only a few species are worth much. Those are value, size, income, momentum, low beta, and quality. In some of its papers, Research Affiliates isn’t even sure “quality” is a legitimate factor, although the firm includes it in its factor appraisals on its website.
Not All Factors Are Equal — Or Always Well-Priced
The question about which factors might be overpriced comes from an argument about data mining. Most factors reflect data mining or observance of a one-time bump in valuation that isn’t sustainable. This has caused a public argument between Research Affiliates and Clifford Asness of AQR Management. If illegitimate factors are the result of a one-time or random bump in valuation, legitimate factors that have persistence can get expensive too. Furthermore, those factors can be embraced or shunned – in effect, timed — based on their relative historical valuations. By contrast, Asness thinks investors are better off sticking with a factor or two they like rather than trying to time them.
Parts of the conference addressed the valuations argument. Research Affiliates thinks momentum and low-beta or low-volatility strategies are expensive. That makes sense given that some investors have driven up the prices of Facebook, Google, and Amazon, and others have sought stock exposure with lower volatility in the aftermath of the financial crisis.
Most value strategies, on the other hand, are relatively cheap. They have suffered as Facebook, Amazon, Apple, Netflix, and Google have propelled growth and momentum indices higher in recent years. But investors might be wrong to choose the factors that have performed the best. Research Affiliates Head of Investment Management, FeiFei Li, gave a presentation showing among other things that choosing the worst performing smart beta factors can lead to better performance than choosing the best performing ones. Valuations are predictive of future returns. In other words, contrarian smart beta investors looking for a “reversion to the mean” might overweight value over momentum based on how each factor is priced relative to its history on the Research Affiliates website.
Li also argued that investors should look at how smart beta funds implement their strategies, because implementation can have a much greater effect on returns than the expense ratio. In particular, high turnover, low weighted-average market cap, and a low number of holdings can be warning signs to investors that a fund isn’t implementing its strategies in the most cost-effective ways.
Morningstar’s Director of Global ETF Research, Ben Johnson, followed Li’s talk with some similar themes. Johnson argued that re-framing factor investing as an evolution of active management was useful. Many traditional stock pickers use factors that characterize ETFs, just not as systematically and mechanically. Johnson also warned investors to be wary when funds with similar factors are introduced at once. That can be an indication that a factor has had a run that’s probably not repeatable.
In my next installment, I will report on the portions of the conference that were concerned with global asset allocation and asset class valuations.
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