Last year demonstrated that diversification and discipline are required to put factors to good use.
A version of this article was published in the December 2016 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor here.
Last year was marked by some dramatic changes in factor leadership. Value made a comeback, while growth lagged. Small-cap stocks had been steadily gaining ground on large caps through much of the year and spiked higher in the weeks following the U.S. election. Low-volatility stocks, which had been outperforming the market at large as well as more-volatile names, were getting left in high-beta stocks' dust.
To be clear, this sort of reshuffling is a regular feature of not just factors, but sectors, asset classes--you name it. The lessons to be learned from these perpetual games of leapfrog are essential. Implementing those lessons is hard.
Reminder: Factors Are Cyclical
Exhibit 1 is the periodic table of factor returns, in which I use various strategic-beta exchange-traded funds as factor proxies. It is immediately apparent that a regular scramble is the norm. I call these factor proxies, as it is important to remember that there is typically a yawning gap between the performance of factors as derived in academia and the investable versions of those same factors represented by these funds. Nonetheless, these funds are some of your best options for harnessing these factors in your portfolio.
Exhibit 2 provides a longer look at the behavior of these funds over the past nine-plus years (for the sake of consistency, I stopped a month shy of including a full 10 years' data). There are a number of important reminders in this data. First, while over multidecade time horizons each of the factors represented by these funds has been shown to produce excess returns relative to the market at large, each can lag the market for long stretches. This is evidenced by the fact that dividend-oriented strategies and value have lagged the broad market over the near decade-long period in question. Second, those excess returns have a cost. That cost can be measured in greater relative drawdowns and overall volatility--as was the case for three of the five funds that outperformed the Vanguard Total Stock Market ETF VTI during this period. Why does this matter? Because, as my colleague and Morningstar FundInvestor editor Russ Kinnel has documented over the years, more-volatile funds tend to be used poorly by investors. Capitalizing on these factors requires that you be on the platform, ticket in hand, when the value, size, or dividend train arrives at the station. These factors have tried many investors' patience, which is coincidentally part of why they exist to begin with. Hanging on requires discipline.
Last year was marked by some swift and sizable changes in factor leadership. There were some common themes among them. Each is a reminder of what I believe to be the core tenets of successful factor investing: discipline and diversification.
Exhibits 3, 4, and 5 are relative wealth charts. They plot the relative performance of the growth of an investment in one fund versus another over time. When the line slopes upward, the fund in the numerator is outperforming the fund in the denominator. For example, in Exhibit 3, you'll notice the line spikes upward beginning at the end of October 2016. During this span Vanguard Value ETF VTV outperformed Vanguard Growth ETF VUG. When the line slopes downward, the opposite is true. And when the line is trending flat, the two funds are neck and neck. This allows us to readily identify trends in the relative performance of different factors.