The widespread reputation of smart beta ETFs demonstrates that factor-based trading has advanced from the province of academia to rank being among the most popular investment strategies for institutional and retail investors. Of interest to analysts seeking to test Originally, and eventually disprove, the effective market hypothesis, factor analysis has turned into a staple in the toolbox of quantitative and fundamental managers alike. In November’s Perception for the Professional we launched our smart beta and factor investing research; we raised some important questions to ask while evaluating these new mass-market quantitative funds.
This month, we delve deeper into the factor risk and earnings, with a specific concentrate on market cycles, one of well-known topics. The broad acceptance and recent success of factor-based investing to create the behavioral risk that investors will begin to see it as a surefire moneymaker, a cure-all because of their collection shortcomings. This research is aware explores the cyclicality of factors and discusses how they could be used to build a strong investment strategy; yet we caution against viewing factors as the superheroes of the investment universe.
Our research examines eleven smart beta factors (displayed by indexes from S&P and MSCI), and presents historical information on come back spreads, correlations, and the impact of market cycles on the success of each factor. Small Cap and Equal Weighted. In the interest of research attention, both people of each pairing were included.
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We start our evaluation with relative return data shown in Table 1, determined as the regular spread between the factor’s return and the core or standard index. For ease of interpretation, to approximate annual data, regular monthly comeback spreads are multiplied by twelve. Our first finding is that, after 35 many years of give-and-take, the Value and Growth styles ended 2016 in almost a dead heat.
The two volatility factors will be the only significant laggards among the eleven factors, publishing negative return spreads of more than 2%. This brings to light an important caveat of Low/Min Volatility investing-the need to distinguish between risk-adjusted and complete results. Low Volatility’s standard deviation of returns is 10.9% set alongside the market’s 14.9%, so on a risk-modified basis the comeback shortfall is offset by the reduced volatility.
Low/Min Volatility may show positive risk-adjusted extra returns because they are low-risk strategies (i.e. the risk penalty is much lower), but on an absolute basis Low/Min Volatility does not show excess come back. Each trader must decide whether an absolute or risk-adjusted perspective best fits their investment circumstances. Dividend strategies likewise have lower return volatility, not surprising given that a larger part of their return comes from stable dividend streams. On the flip side, return volatility for High Small and Beta Cover are above the market’s level, indicating that the excess come back from these factors is shipped in a bumpier fashion.
The fourth numeric column in Table 1 shows the percentage of a few months in which the factors excess comeback was positive. We believe market stages or cycles are critical to understanding any investment approach. We applied this perspective to our factor analysis by identifying bull and bear market phases since 1980 and segmenting factor returns predicated on this distinction. Reviewing the last two columns in Table 1, we were amazed by the moderate alpha most factors experienced in bull marketplaces. Only High Beta gained more in bull marketplaces than it did overall, posting a 9.0% unwanted return in up markets.
The other ten factors had bull market alphas lower than their overall ratings and six are negative. Both dividend measures underperformed in bull markets, and volatility factors lagged significantly. Looking beyond High Beta, Size, and Momentum seem to be the next most favorable exposures during bull runs. While factor returns leave something to be desired in bull markets, they blow the doors off in bear markets. From High Beta’s horrific results Aside, most others performed very well, led by the volatility and dividend pairs that have double-digit spreads. Quality and Momentum also nicely did, and the Value/Growth style calls performed as expected but to a far more muted degree than the factors themselves.
The lesson from these columns is that factors can hold their own in bull marketplaces (, and selectivity is not important as long as you avoid Low/Min Volatility), but they shine in keep market cycles, providing outstanding value-add over the board. Clearly, understanding market phases is critical to anticipating factors’ excessive return in the years ahead.