Christine Benz: Hi, I'm Christine Benz for Morningstar. Can investors beat the market by timing their exposure to various market segments or factors? Joining me to discuss some research on that topic is Alex Bryan. He is director of passive strategies research for Morningstar in North America.
Alex, thank you so much for being here.
Alex Bryan: Thank you for having me.
Benz: We have talked a lot about factors over the past few years. But let's just refresh everyone's memory about what we're talking about when we say a "factor" when it comes to putting together an ETF.
Bryan: A factor is basically a common set of characteristics, like low valuations or market capitalization, that can help explain and predict stock returns or different asset returns. Over the long-term certain characteristics like low valuations, strong recent performance or momentum, and quality and some other things have tended to be associated with higher returns than the market over the long term, and that's what we mean by factor.
Benz: This idea of timing among different factors, let's talk about the rationale for that, why you might, say, heavily overweight small-caps but then decide you want to be in momentum, or something like that. What's the rationale for this idea of rotating among different factors?
Bryan: While each of these individual factors has tended to work well over the very long-term, they each go through stretches of underperformance. Value is a good case in point. The last decade has been atrocious for value. I think everybody who has been in value has thought to themselves, well, this was certainly not what I signed up for; it would have been nice if I could have predicted this ahead of time. The basic idea behind factor timing is, if you can get some insight into when a certain factor can do well, perhaps you can tilt into the factors you expect to do well, away from the ones you expect to underperform, and maybe improve performance as a result of that.
Benz: Let's talk about what sorts of indicators that investors might look to to decide, well, it's time to get out of this factor and rotate into this factor. What are some of the things that researchers look at?
Bryan: The research into factor timing is a relatively new area of work, and most of it's been done in the asset management industry. You haven't had a lot of independent research done from the academic community. But that being said, the preliminary research that's been done suggests that there might be something to factor timing based on signals that fall into four broad categories, one of which is looking at economic indicators to determine what state of the economy we are in, whether we are in a contraction, an expansion, a recovery or a slowdown.
Another combination of signals that a lot of researchers look at is the value of each different factor. You can think of this as the value of a value or the value of momentum looking at the valuations of the portfolios of factor stocks themselves.
Momentum is another type of indicator that people look to. They say, low-vol has done well over the last year, perhaps it will continue to do well over the next year relative to some of the other factors.
Finally, the fourth bucket of indicators goes under this category called dispersion -- looking at how much variation there is along each of the dimensions on which these factors are measured. For example, if we are looking at profitability among U.S. stocks, the dispersion indicators would suggest that the payoff to profitability would be the greatest when there's a bigger difference than normal between high profitability stocks and low profitability stocks based on how profitable they are. Those are the four broad categories in which these timing signals fall into.
Benz: On the surface this might seem really compelling, this idea of, at one point, you will be in this high-performing factor and then rotate into one that you think might perform better. But I think it's probably a lot like timing asset class exposures in that it's really difficult to do. Why would you caution investors about proceeding with such a strategy?
Bryan: Timing anything is very difficult. I mean, take the market, for example. We all know that the market tends to do better during recoveries than during slowdowns. But it's really hard to know what state of the economy you are in at the time. With hindsight, yeah, it's pretty easy to go back, oh, yes, well, if only you had bought stocks in 2009, you would be in really good shape now. But in the moment, it's very difficult to know where you are.
There's lots of indicators researchers can look at, and one risk that we have is data mining where you can literally comb-through thousands of data points and just by chance, you're probably going to find something that works. But in order to get confidence that there's something to this, you really need a lot of out-of-sample testing, a lot of it. There just hasn't been a lot of that research done yet …
Benz: And what is out-of-sample testing?
Bryan: It's basically where we take this model that researchers have found, these indicators look to tell you when a certain factor would do well. And we look at a different set of data and say does this indicator work in that set of that the initial researchers didn't even consider when they were developing that model. It's a way of basically checking the intuition to make sure that the researchers didn't overfit the original sample when they were building their model.
That certainly is a risk. But I think one of the other risks is that--and this is something a lot of people don't think about--but a lot of times, when you think about timing into factors, you give up one of the key benefits of being a multfactor investor, and that's diversification. Anytime you increase your exposure to one factor and away from another, you are increasing your bet on that one factor. If that doesn't work out, if you're wrong, you're going to hurt yourself more than if you had just stayed put and kept a static allocation of different factors.
Benz: The risk of underperforming is obviously one big risk. But there are some other potential drawbacks to using this factor timing strategy. Let's talk about that.
Bryan: Loss diversification is the most important one, especially if you are using value to time your exposure to these different factors. You risk doubling down on value, because the performance of the dynamic strategy is actually a bit correlated with the performance of the value factor itself. You also lose that broad diversification across factors.
The other issue is that you increase your active risk or your risk of underperforming the market because you are leaning into certain factors more aggressively at different times in the cycle. And if those factors don't pay off, you get hurt more. Then finally, transaction costs are higher anytime you try to rotate in and out of different strategies.
These are considerations that I think should give a lot of investors pause, particularly now that the research really hasn't been independently vetted as extensively as would like to see as some of the original factor research itself.
Benz: It doesn't sound like you like a lot of the factor timing funds and ETFs. But for investors who are compelled by this idea of owning multiple factors in a single portfolio, how should they go about it?
Bryan: I think the best course of action is to identify a set of diversifying factors in which you believe, so factors that have low correlation with one another, and to stick with them. I think the most effective way of doing that is with a multifactor ETF or a multifactor fund.
One fund that we really like here is the iShares Edge MSCI Multifactor USA ETF; the ticker is LRGF [Editor's note: The fund is also sold in Canada under the ticker XFS]. This particular fund maintains a static allocation to four different factors. Looking for stocks with the best combination of attractive valuations, strong momentum or recent stock performance, strong quality characteristics, and relatively low market capitalization. Each of those four factors has tended to pay off over the long-term. They tend to work at different times. Having a diversified exposure to those four different factors is a really good way of diversifying your risk while still maintaining the upside if those factors do work out.
With this fund, you don't have to worry about trying to time your exposure in these factors. Sometimes value is not going to work out, sometimes momentum is not going to work out. But because you have diversified exposure, not all your eggs are in one basket. Over the long term, if those factors work out, as I believe they will, I think fund will stand to benefit from that. Importantly, it's charging a competitive 20 basis points expense ratio so you're able to keep a lot of the returns that the fund generates.
Benz: Alex, interesting research. Thank you so much for being here to share it with us.
Bryan: Thank you for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.
