More turmoil ahead? Factoring in factor ETFs
If you take a look at the VIX — the ‘ fear index’ that aggregates the embedded volatilities in the U. S. options market — you’ll see that it spiked with a vengeance last August.
This move coincided with China devaluing the yuan, ever so slightly. Since then, the VIX has settled back, though not without first taking us through the most tumultuous January on record, and, this week, the ECB’s allout move to ensure a favourable market reaction to its latest stimulus measures.
Is there more turmoil ahead? And if so, what should investors do about it? While February provided a measure of respite in the markets, there is no way to preclude the possibility of more volatility in the months to come. As for the what to do, there will be many different answers, depending on your individual situation, your starting position, and importantly, your viewpoint on how things will play out — keeping in mind that ultimately everyone is just making an educated guess.
One interesting potential area to explore are factor ETFs, which attempt to isolate a single factor — such as volatility, value, momentum, growth and yield. The accompanying chart includes the six- month performance of several factor ETFs alongside that of their traditional S&P/ TSX composite counterpart, the iShares Core S&P Capped Composite Index ETF (XIC).
As the results show, it was a difficult period, even if things improved in February.
Considering t he vast amount of empirical studies suggesting most managers fail to beat the market either consistently or over time, “buying the market” — in this instance XIC — remains a valid strategy.
Many though — out of personal biases, or out of a belief that pure passive indexing is just too good to be true ( can it really be that easy?) — are increasingly opting for so- called “Smart Beta” strategies, often available in an ETF.
According to the latest FTSE Russell Smart Beta — 2015 Global Survey, 47 per cent of those evaluating “smart beta” ETFs expected to make an allocation within the next 18 months, while another 47 per cent didn’t know, and the remaining 6 per cent weren’t expecting to make an allocation.
From a satisfaction standpoint, the survey results reported that 61 per cent of owners were either satisfied or very satisfied, only 2 per cent dissatisfied, while 27 per cent reported it was either too early to rate or didn’t know.
What will investors do, meanwhile, when meaningful divergences in the respective smart beta solutions selected materialize? Will they abandon the strategies? Will they attempt to move among factor solutions? Or will they, as already seems to be the case, opt to diversify among more “smart” strategies?
With the latest headline out of the U. S. suggesting value as a factor has now underperformed for most of the past 10 years, we are reminded that factors can be on the wrong side of pure passive indexing for extended periods of time.
Leaving aside size— which in Canada hasn’t produced much of a return premium in a while, and quality, for which there isn’t yet an ETF, the table above presents ETFs providing exposure to “volatility” strategies ( aiming to reduce volatility), value, momentum and growth.
As First Asset’s Canadian Value and Momentum ETFs marked their 4th anniversary this past month — having beaten the market over said four years, it is interesting to note that both strategies have encountered rougher seas since last summer.
Going forward, the question, given their welldocumented longer-term potential to outperform, is whether their current relative strength deficit presents an opportune entry point?
And if not, what of the other strategies? Any way you look at it — depending on the actual details and exposures of the underlying methodologies, performance dispersion means an opportunity to reassess which factor you want to stick with, or whether jumping ship could be worthwhile.
Remember though — timing factors could be as challenging as timing markets overall, all the while the discipline embedded within their screening methodologies should generally provide you with the discipline to stick to the factor or factors selected.