Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Market leadership changed dramatically in 2016. Joining me to discuss what has been going on as well as what investors should make from the recent market action is Morningstar's director of ETF Research, Ben Johnson.
Ben, thank you so much for being here.
Ben Johnson: I'm glad to be here, Christine.
Benz: Ben, I want to take a closer look at a piece you wrote for ETFInvestor, where you looked at what has been going on in the market and its relationship with factor investing. But let's start by talking about what factor investing is. It's sometimes called strategic beta investing. What's the basic idea there, versus just buying a very cheap total market index fund and calling it a day?
Johnson: So, factors are fundamental drivers of investment returns. And when you look at equity markets and stock market returns, the most meaningful driver of stock market returns, the one that's doing most of the heavy lifting is just equity risk. It's beta. So, strategic beta, factors, smart beta--whatever you want to call this--are all supplemental to market beta. And these individual factors include things like value and momentum, which I would argue are sort of the bedrock factors. So, value, buying securities that are cheap relative to some measure of their intrinsic value. Momentum, being the tendency of securities that have appreciated in price recently to continue to appreciate in price over the near term or vice versa. These are supplemental to beta, just that equity market return and again, are the fundamental drivers of returns on stocks, on bonds, on other securities.
Benz: So, the basic idea is that you're going to drill into to maybe a smaller subsection of a total market in an effort to capitalize on what academic research and indeed, real market performance show is outperformance of these various cuts of the market at points in time?
Johnson: Absolutely. So, investors who are looking to use these factors or funds that try to harness these factors are saying beta isn't sufficient for me. I'm not satisfied with owning just a total stock market index fund or a total bond market index fund. I want something more by way of returns, or perhaps I want something less by way of risk. Low volatility as a factor and certainly the investable forms thereof, be it the exchange-traded funds or certain portfolios' index mutual funds and actively managed funds that promise to take some of the sting out of drawdowns in equity markets have been very popular of late.
Benz: So, let's take a look at the big rotation we saw in 2016 in terms of factor leadership. Let's talk about what changed, what factors began to underperform and which began to outperform, and what you think were the catalysts for that big rotation in factor leadership.
Johnson: Well, as you alluded to, we saw some pretty dramatic reversals in factor leadership, especially later in the year. And this is important because it serves as a useful reminder of the inherent cyclicality of the performance of different factors. I think when most investors first approach factor investing when they look at the academic literature, when they look at, say, fund sponsors' marketing materials, what those cohorts will typically lead with is, oh, look, over a very long period of time, typically multiple decades, value will outperform the market at large, will outperform, say, growth as a style, what have you. What goes missing beyond that lead is the fact that in the intervening years over any 10-, 20-, 30-, or 40-year period, there will be, in some cases, very pronounced degree of cyclicality with respect to that particular factor's performance. Value is a perfect case in point. Value is a factor and certainly value-oriented funds have been lagging their more growth-oriented peers now for the better part of a decade.
Benz: You wrote about that just a couple of months ago. Value's long dark night or whatever you call it, this idea that value had been lagging for a long period.
Johnson: It went out for a walk in the woods and was perhaps never going to come back. But what we saw in late 2016 is that value made a very dramatic comeback. So, value took the lead over growth certainly in the back half of 2016. We saw a similar change in leadership between large and small-cap funds. Small-cap funds skyrocketed in the later months of 2016. We saw a similar change in leadership between low and high-volatility stocks, so, low-volatility stocks and high-beta stocks.
And fundamentally, what was underpinning all of these changes in leadership was what has been referred to in sort of market narratives is this reflation trade. So, if you unpack the drivers of these investable funds' returns, what you saw is that the changes in leadership were driven really by the resurgence of certain deeply cyclical sectors--energy, industrials, and materials, in particular, where sort of a common theme among those factors that again took the lead that had been lagging for a number of years in some cases.
Benz: So, a question is, I think investors might see these cyclical moves and might be tempted to say, well, OK, maybe I think some of these beta factors will lead for a good long time. So, maybe I'll back up the truck for them, downplay, say, the low-volatility funds that had a bigger role in my portfolio in the past. You say that it's really important that investors not try to get too fancy in terms of trying to time their entry and exit points from various factors?
Johnson: Absolutely not. I think when it comes to factors as is the case when it comes to anything, sectors, individual stocks, asset classes, timing is folly. Timing in likelihood is going to set you up for failure. What we've seen is that these factors historically are very cyclical that the payoffs to these factors can come in very short bursts. So, if you're not on the platform when the value train comes into the station with your ticket in hand, you're not going to capture that premium.
So, successful factor investing, in my mind, requires a combination of discipline and diversification. And I don't think those two are necessarily mutually exclusive. In all likelihood, I believe that if you build a more diverse portfolio of factor exposures, it will increase the likelihood that you will have the discipline to stick with that diverse basket of exposures through thick and through thin, because what we see is when you bring these factors together under one roof, each of their individual cycles does not sync up, and you see this embodied in the reversals we saw late last year. High beta will have a season and when high beta comes into favor, low beta will go out of favor. When value comes into favor, growth may fall out of favor, large-cap, small-cap, what have you. So, having a diversified basket of these factor bets I think is the best approach, and I think it will increase the likelihood that you can take a more disciplined approach to stick with these factors across an entire market cycle.
Benz: So, there will be two key ways to build that diversified basket of factors. One would be to do it sort of on an a la carte sort of way where you just buy the ETFs one-by-one and another way to do it would be to buy a multifactor ETF that bundles together different factors. Do you have a preference among these two approaches?
Johnson: I think the decision between taking the do-it-yourself approach, so building a portfolio using individual factor funds, and the do-it-for-me approach, so investing in a multi-factor ETF, is really a personal decision. We've certainly heard from any number of investors who are far more comfortable and very savvy and have a strong preference for piecing together those individual factors themselves, for those who are less conversant in factors, for those who simply don't have the time, the energy or the interest in managing those individual factor funds themselves, there are a number of suitable options that are multifactor constructs that give them sort of a one and done way to go about trying to achieve something more than just a broad-based beta exposure that they might achieve through a total stock market fund.
Benz: Well, I guess, that's the sort of last follow-up question is, once you bundle together all these factors, is there a chance you will end up with something that has, at the end of the day, a risk-return profile a lot like the broad market?
Johnson: The only guarantee is that you are going to get something that is in some way different from the market. So, you are deviating from a purely passive market capitalization-weighted beta exposure. And that is important to note because that by definition is an active bet. So, while all of these various factor ETFs and index funds are at least nominally passive, they are passive by way of their implementation. The design of the index that underlies them is inherently active. It is a bet against some form or another of broad market cap-weighted exposure; it is an attempt to do something more by way of capturing incremental returns or get something, as I mentioned before, a bit less by way of volatility. So, it's an active bet. And not unlike any other active bets, it might not pay off relative to owning the market, and if it does pay off, the road between an investor and that ultimate payoff is going to be winding.
Benz: Ben, interesting research. Thank you so much for being here to share it with us.
Johnson: Thank you for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.