data points. These strategies ... equity markets, as was the case in 2017, but may suddenly drop off should ... This fac
2Q2018
Quarterly Perspectives
Factor Investing: An Overview Factor investing (also called “Smart Beta”) focuses on identifying and investing in certain styles or themes. According to Morningstar, these strategies (dubbed “Strategic Beta” by the firm) seek to enhance returns by using transparent and rules-based approaches to target specific investment attributes (like value, growth, quality, low volatility, and momentum). Factor-based strategies tend to charge fees that are higher than a traditional index or exchange-traded funds (EFT), though are generally less expensive than traditional actively-managed investments. While actively managed strategies as a whole have struggled to retain assets post-financial crisis, index funds and ETFs have raked in assets. The chart below shows fund flows for ETFs utilizing factor-based strategies versus all actively managed strategies over the trailing three years. The factor-based funds experienced only a handful of months of negative flows compared to nearly two-thirds of the months for actively managed strategies. Estimated Fund Flows Strategic Beta Strategies
Actively Managed
40 20
Billions
0 -20 -40 -60 -80 Apr-15 Aug-15 Dec-15 Apr-16 Aug-16 Dec-16 Apr-17 Aug-17 Dec-17
A plethora of factor strategies have cropped up in the last few years and investors must take care when considering these investment options. Academia has largely agreed on a handful of factors that have been proven to outperform over the long term—value, growth, size (small), quality, low Source: Morningstar
volatility, and momentum—but how asset management firms package these factors into investable securities can vary widely. Investors must proceed with caution.
The Factors of Life The value factor is one of the most well-known and has widespread academic support. Value measures the comparative “cheapness” of a stock using any number of data points. These strategies typically rank the universe of stocks by “cheapness” and purchase the cheapest names. This strategy is likely to suffer in broad-based selloffs as those cheap companies often have characteristics that investors deem riskier and are more eager to sell. Alternatively, the growth factor focuses on firms with high historical and future earnings and revenue growth. Strategies can be as simple as ranking the universe by “growthiness” and buying those with the highest growth characteristics. These strategies can be high flying in strong equity markets, as was the case in 2017, but may suddenly drop off should the economic picture become less rosy. Momentum is a strategy that relies on buying past winners and selling past losers. The strategy can be as simple as purchasing stocks with the highest price return over a specified period of time with regular rebalancing. The theory behind this is that markets tend to keep moving in the same direction (either up or down) until they don’t, and the trend reverses. This strategy is likely to do poorly in fast-moving markets as sudden drop offs or snap backs are difficult for this strategy to either avoid or participate in. The quality factor refers to the quality of the underlying business and typically favors firms with low leverage and high returns on equity. Because the definition of quality is a bit squishy, there can be high variability among investments following this strategy. This factor tilt may allow a fund to do better during a market decline because, theoretically, higher-quality companies should be favored by investors in times of stress.
The low volatility factor is, at its simplest, one that buys stocks that have experienced the lowest volatility over a specified time period, rebalancing regularly. Implementation of this factor can vary widely among index providers so it’s important for investors to understand how this universe is sliced and diced.
volatility factor has tended to hold up better in period of stress, though that is not an absolute—it was down more than the broader index during the first quarter of 2018 as that index can be dominated by so-called bond proxies (utilities, for example) which tanked along with the stock market in late January, providing little of the diversification benefit historically afforded to that strategy.
Finally, asset management firms have begun to launch “multi-factor” investment strategies that seek to combine factors. Some managers will tactically allocate to factors as they go in and out of favor, others will balance the factors more statically over time in an effort to maintain some level of diversification.
Before investors consider adding a factor-based strategy to their portfolio, a few important issues should not be ignored: Each
fund provider can define factors differently which leads to dispersion in return patterns even among the same factor-based investment options.
Factoring It All In
Isolating
Though historical data can be limited on individual strategies, Standard & Poor’s has numerous factor indexes, some with long histories. Below, return and risk metrics for the five factors discussed above plus the broad-based S&P 500 index are shown. Past performance is not indicative of future results.
Factors
tend to fall in and out of favor, sometimes for long periods of time.
Adding
a factor tilt to a portfolio may over expose investors to that factor depending on the inherent leanings of the other portfolio holdings.
In all, factor ETFs are no different than any other investment option. Investors need to fully understand what goes on under the hood and to have realistic expectations about performance in various market conditions before purchasing them.
Each factor has performed alternatively well and poorly in different market environments. A prolonged period of underperformance for value and an alternatively strong environment for growth led those two factor indices to land behind and ahead, respectively, the broader S&P 500 index over multiple trailing periods though March 2018. The low
Annualized Returns (%) Name S&P 500 Value S&P 500 Growth S&P 500 Momentum S&P 500 Quality S&P 500 Low Volatility S&P 500 Index
Q1 2018 -3.57 1.93 3.39 -1.47 -0.86 -0.76
1 Yr 7.69 19.69 25.32 11.56 10.63 13.99
3 Yr 8.40 12.66 12.76 – 9.99 10.78
5 Yr 10.87 15.37 14.51 – 11.45 13.31
a single factor will likely generate higher volatility.
Standard Deviation (%) 1 Yr 9.32 9.22 10.54 8.18 7.26 8.47
3 Yr 10.53 11.06 10.91 – 9.15 10.26
5 Yr 10.13 10.44 10.38 – 9.15 9.87
Stress Period Returns (%) Tech Bubble 2008 Financial 2018 Q1 Burst Crisis Correction -7.82 -38.48 -9.29 -19.75 -28.64 -8.78 -23.41 -27.22 -8.59 – – -8.62 13.69 -21.41 -7.42 -32.82 -45.80 -9.03
Source: Morningstar The S&P 500 Value Index measures the performance of the large-capitalization value sector in the US equity market. It is a subset of the S&P 500 Index and consists of those stocks in the S&P 500 Index exhibiting the strongest value characteristics. The S&P 500 Growth Index consists of growth companies in the S&P 500 Index. The S&P 500 Momentum Index tracks high momentum stocks from the S&P 500 Index and is rebalanced twice a year. The S&P 500 Quality Index measures the performance of Large Cap securities and is selected by a Fundamental process. The S&P 500 Low Volatility Index consists of the 100 stocks from the S&P 500 Index with the lowest realized volatility over the past 12 months. The S&P 500 is an American stock exchange market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. The S&P 500 index components and their weightings are determined by S&P Dow Jones Indices. Mesirow Financial refers to Mesirow Financial Holdings, Inc. and its divisions, subsidiaries and affiliates. The Mesirow Financial name and logo are registered service marks of Mesirow Financial Holdings, Inc. © 2018, Mesirow Financial Holdings, Inc. All rights reserved. Some information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete and its accuracy cannot be guaranteed. Any opinions expressed are subject to change without notice. Advisory Fees are described in Mesirow Financial Investment Management, Inc.’s Form ADV Part 2A. Mesirow Financial does not provide legal or tax advice. Advisory services offered through Mesirow Financial Investment Management, Inc. an SEC registered investment advisor. Securities offered by Mesirow Financial, Inc. member FINRA and SIPC.
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