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Do Industry Tilts Matter in Factor Investing?

Alex Bryan, CFA
Christine Benz

Christine Benz: Hi, I'm Christine Benz for To what extent does the success of various factors depend on bets on specific sectors? 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: Before we get into your research, I'd like to talk about--what is a factor?

Bryan: Sure. So, a factor is basically a characteristic that helps explain an asset's return. So, for example, stocks that have been trading at low valuations or that have had strong recent price appreciation have tended to outperform over the long term. So, these factors are basically these common characteristics that many different stocks or other types of assets may have. There's been a lot of funds that have been launched in the last few years that try to take advantage of these characteristics that target stocks with these common factors that have historically been associated with better performance.

Benz: OK. So, the idea behind the research was to take a step back and say, well, to the extent that these factors have succeeded, to what extent have their emphases on various sectors at various points of time been one of the main drivers of that?

Bryan: Yes. So, we were trying to separate out the contribution of these industry tilts on the success of these different strategies. That's important because whenever you buy a factor strategy, a lot of times that comes with certain sector tilts, overweighting certain sectors. So, for example, if you buy a traditional market-cap-weighted value fund, it is almost always going to be overweight financial services stocks because banks tend to trade at lower valuations than, say, technology stocks.

When someone thinks about value investing, they may not think about making an active bet on banks or technology. They may be just thinking about, OK, I like the idea of buying assets that are cheap, but there's certainly some good reasons why banks are almost always trading at lower valuations than tech stocks. I mean, they tend to have lower growth rates and there may be other risk factors involved. So, we wanted to say, OK, well, would be possible to capture the benefit of these factor strategies without potentially taking these industry tilts that are additional sources of risk.

Benz: OK. There are actually products on the market today that attempt to kind of neutralize some of these sector bets. So, for example, if you're buying one of these value products, they may put some guardrails on how much it can put in the financials sector?

Bryan: Absolutely. Some of these newer products out there have been designed to try to rein in some of these sector tilts so that investors can be a bit more intentional about the active risk that they want to take. Any time you deviate from the market, you're taking a form of active risk. So, the question is, when we looked at this landscape of new products, is there merit behind this? How important are these industry tilts? So, that was really the genesis of the research project.

Benz: OK. Well, let's talk about your finding, because I think there are some interesting implications for investors who might be inclined to focus on a single factor, maybe a few different factors. So, let's talk about what you and your co-researcher found.

Bryan: Sure. So, what we found was that industry tilts were not all that important for the success of the value factor. In fact, they didn't really contribute much at all over the long-term to the success of the value factor. So, that would suggest that potentially a sector-constrained value fund may be the way to go there if you want to mitigate unnecessary active risk.

What we found on the low volatility side of things was that stock selection rather than industry selection tended to drive most of the outperformance of the low volatility factor. But sector selection did contribute a little bit, but just not a whole lot. Most of the mileage came from stock selection.

Momentum was actually a really interesting case, because unlike value and low volatility, actually industry selection was pretty important to the success of the momentum factor. So, those results were quite interesting. The findings did depend, as you mentioned, on the factor that we looked at.

Benz: So, can you, kind of, unpack that factor-by-factor starting with value, maybe going to low-vol and then on to momentum?

Bryan: Sure. So, if you think about value, the types of sector tilts that a value strategy will have tend to be very long-term and very static. As I mentioned, banks almost always trade at lower valuations than technology stocks.

Benz: And is it simply that market participants just don't think their growth prospects are as attractive as might be the case with some other sectors?

Bryan: That's part of it. Part of it is due to differences in their business structures. I mean, banks obviously have a lot more debt on average than a typical tech stock. So, there's some risk involved that help explain differences in the valuations between the different securities. It is a little bit like comparing apples and oranges. The businesses are very different. So, if you are looking at book value, book value for a tech company is very different than book value for a financial services stock. Tech companies don't have a lot of book value. So, by that virtue alone, they are going to tend to trade at higher price/book ratios. But anyway, these tilts tend to be pretty static. So, there isn't a lot of informational content embedded in these sector overweightings. Over the very long-term there isn't a huge spread in the returns across various sectors. And if you are consistently overweight certain sectors, you don't really earn higher returns as a result. So, that's why, I think, for value we saw that these industry or sector tilts didn't really add all that much in the way of returns.

If you look at low volatility, you have similar type of static bets. Utilities almost always have lower volatility than, let's say, consumer cyclical or industrial stocks. There is a little bit more change in terms of the sector composition of a low-vol strategy but it's still pretty static. And again, you're not going to pick up a lot of informational content there. Also, there is more variation in volatility when you go stock-by-stock than there is across various sectors. So, again, most of the mileage from the low volatility factor has come from stock selection.

Now, if you look at momentum in contrast, the sector allocations there tend to be a lot more dynamic. The price appreciation of each sector--the price leadership will change over time. And momentum by leaving the sector composition unconstrained is able to capture that short-term leadership in performance more effectively than a constrained version of that strategy. I think price is one of the most comparable metrics. It's a lot more comparable than valuations, for example, across different industries because price returns in the tech sector are the same as what they are in the financial services sector. So, you have better comparability with momentum. And momentum is able to capture the short-term phenomenon where recent performance tends to persist. So, leaving the sector weightings unconstrained there will allow you to capture the momentum benefit more effectively than constraining them.

Benz: OK. So, you brought with you some favorite exchange-traded products within each of these factor spaces. Value, we talked about, you talked about how that's an area where maybe I do want to think about using some sort of a relative value strategy so that I can pick up exposure across the sector spectrum. What sort of product do you like in that particular area for the value factor where you are getting some sector diversification?

Bryan: So, one of the funds that we really like that does constrain its sector weightings is the iShares Edge MSCI USA Value Factor, ticker is VLUE. This is a fund that carries a Morningstar Analyst Rating of Bronze. When it rebalances twice a year, it basically sets its sector weightings equal to its selection universe which is the market-cap-weighted MSCI USA Index. And what it's trying to do is target the cheapest stocks within each sector. So, it's comparing tech stocks against other tech stocks; it's comparing financial services stocks against other financial services stocks.

So, I think, there's a couple of advantages here. One, I think, there is more information contained in these sector relative comparisons. But secondly, you are being more intentional about the risk that you are taking. So, you really are isolating that value factor component and you are not depending on the performance of certain sectors to drive the performance of the fund. So, its sector weightings are going to be very comparable to the overall composition of the market.

Benz: OK. How about within the low volatility space? It sounds like based on your research finding that that's an area where the sector bets would be a little less important but nonetheless something to consider?

Bryan: Absolutely. So, one of the funds that I really like here is another iShares product, iShares EDGE MSCI USA Minimum Volatility ETF, ticker is USMV. So, this product basically constrains its sector weightings to within 5 percentage points of the selection universe which is the MSCI USA Index. So, you do still tilt toward some of the more defensive areas of the market, like utilities, like consumer defensive and healthcare, but those weightings are being reined in, which is important, because if you leave those weightings unconstrained as one of this fund's competitors does, the PowerShares S&P 500 Low Volatility Fund, you get a much larger tilt toward utilities and consumer defensive stocks. So, I like this because it reins in those sectors weightings. It allows you still to tilt toward the more defensive areas of the market, but doing so in a way that better preserves diversification. So, I think, that's a better product if you were thinking about parking a large portion of your portfolio in a low volatility strategy.

Benz: OK. Finally, momentum--based on your research, it sounds like that's an area where I want to give my fund or my ETF, whatever it might be, a lot of latitude to roam across sectors.

Bryan: Right. And most fund providers realize this and they leave their sector weightings unconstrained for momentum. But among the momentum funds out there the one that we happen to like the best is the iShares Edge MSCI USA Momentum Factor. We like is because it charges a very low 15 basis points expense ratio. It only rebalances twice a year which--that does somewhat dilute the purity of the strategy, but it does help rein in transaction costs. So, I think, this is a very cost-efficient way of getting exposure to the momentum factor. And as you mentioned, it leaves its sector weightings unconstrained. So, the composition of the portfolio can change quite a bit year-to-year.

Benz: OK. Alex, interesting research. Thank you so much for being here.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for