We believe key stock factors can indeed improve long term returns over a vanilla market capitalization based stock index such as S&P 500 index (SPY). Specifically, we believe the following four factors can be used to construct a better US stock portfolio (again, over a broad based index such as S&P 500):
- Value factor: invest in stocks with lower valuation (i.e. cheaper)
- Momentum factor: invest in stocks with high price momentum
- Quality factor: invest in stocks with high quality (i.e. consistent profit) underlying business
- Low Volatility factor: invest in stocks with lower overall portfolio volatility when put together
Note: low volatility factor does not simply mean picking stocks with low volatility, instead, it’s to choose stocks to form a portfolio with low volatility.
For example, MSCI defines its minimum volatility factor portfolio of stocks as follows:
The MSCI Minimum Volatility Index is constructed using the Barra Optimizer3 in combination with the relevant Barra Equity Model. The optimization uses the Parent Index as the universe of eligible securities and the specified optimization objective and constraints to determine the optimal MSCI Minimum Volatility Index. The Barra Optimizer determines the optimal solution, i.e. the portfolio with the lowest total risk, using an estimated security co- variance matrix under the applicable investment constraints.
Basically, the portfolio (i.e. stocks and their weights) is derived using an optimizer that tries to minimize the total risk under certain constraints such as maximum or minimum weights of sectors (or countries if it’s an international index). So the factor portfolio consists of stocks that, together, achieve lowest risk (or volatility). But individual stocks don’t necessarily have low volatility.
For example, on 4/17/2020, the MSCI US MV (Minimum Volatility) factor index’s largest position was Newmont Goldcorp Corp (NEM), a stock by no means has low volatility. However, since this gold mining stock has low or even negative correlation with other stocks, its addition can actually hedge out other stocks’ volatility and thus reduce the overall volatility.
In this article, we first review popular factor ETFs and multi-factor ETFs. We then look at how our multi-factor rotation portfolio has done recently.
Recent performance of factor ETFs
Let’s first take a look at the four representative (and largest) factor ETFs’ YTD (Year To Date) returns:
Their more detailed return data (as of 4/20/2020):
|ETF||YTDReturn**||1Yr AR||3Yr AR||5Yr AR|
|VTV (Vanguard Value ETF)||-19.7%||-10.6%||3.7%||5.4%|
|MTUM (iShares MSCI USA Momentum Factor)||-6.6%||5.4%||13.4%||11.7%|
|QUAL (iShares Edge MSCI USA Quality Factor ETF)||-13.1%||-3.0%||8.1%||8.0%|
|USMV (iShares MSCI USA Minimum Volatility)||-10.3%||0.4%||8.7%||9.1%|
|GSLC (Goldman Sachs ActiveBeta US LgCp Eq ETF)||-11.8%||-1.1%||8.7%|
|LRGF (iShares Edge MSCI Multifactor USA ETF)||-16.8%||-9.1%||2.9%|
|SPY (SPDR S&P 500 ETF)||-12.5%||-2.4%||8.1%||8.0%|
|VTI (Vanguard Total Stock Market ETF)||-13.9%||-3.7%||7.3%||7.2%|
AR: Annualized Total Return
From the above, we can observe what happened in the recent crisis:
- Momentum and low volatility ETFs (MTUM and USMV) have done the best in the crisis, while Value (VTV) did the worst. In fact MTUM’s YTD loss is only 1/3 of VTV’s.
- Both MTUM and USMV did better than SPY YTD, 1 yr, 3 yr and 5 years. Quality (QUAL) is about the same as SPY.
- Value has definitely lagged behind so far for the past 5 years.
- Multi-factor (GSLC) did slightly better than SPY. On the other hand, to be fair, as most factor ETFs are choosing stocks out of MSCI stock index, GSLC did better than VTI. However, LRGF, an MSCI multi-factor ETF, did much worse than VTI. This indicates a difficulty to just simply use all four factors to outperform a broad base stock index.
Factor rotation using composite momentum
The portfolio P Composite Momentum Scoring Factor ETFs listed on Advanced Strategies uses momentum scores to pick the top performing ETF out of the four ETFs, MTUM, VTV, QUAL, USMV mentioned above, monthly. Furthermore, it also uses a market indicator that’s based on broad base stock index momentum and other factors including market divergence, credit spreads and valuation to decide whether to have exposure in stocks or just simply invest in an intermediate term Treasury ETF (IEI) or (MUTF:VFITX). For example, it decided to turn the portfolio to Treasury bonds by the end of February this year.
The following table compares the recent returns (as of 4/20/2020):
|Ticker/Portfolio Name||YTDReturn**||1Yr AR||3Yr AR||5Yr AR||5 Yr Max Drawdown|
|P Composite Momentum Scoring Factor ETFs||-5.5%||7.1%||15.1%||12.8%||-18%|
|GSLC (Goldman Sachs ActiveBeta US LgCp Eq ETF)||-11.8%||-1.1%||8.7%||-34%|
|(USMC) (Principal US Mega-Cap Multifactor ETF)||-7.7%||2.3%||-30%|
|LRGF (iShares Edge MSCI Multifactor USA ETF)||-16.8%||-9.1%||2.9%||-36%|
|SPY (SPDR S&P 500 ETF)||-12.5%||-2.4%||8.1%||8.0%||-34%|
Multi-factorEqualWeight is a static portfolio that invests equally in the four factor ETFs.
As a comparison, we list the table listed in last October:
Portfolio Performance Comparison (as of 11/1/2019):
|Ticker/Portfolio Name||YTDReturn**||1Yr AR||3Yr AR||5Yr AR||5Yr Sharpe||AR Since 7/19/2013|
|P Momentum Scoring Factor ETFs Momentum Value Low Volatility Quality||23.2%||18.4%||21.0%||15.7%||1.11||15.7%|
|VFINX (Vanguard 500 Index Investor)||24.2%||14.1%||15.4%||10.8%||0.75||12%|
- The simple minded Equal Weight 4 factor portfolio did poorly compared with GSLC, which wasn’t the case when we looked at them in last October. This indicates that GSLC was able to do a better job in the current crisis.
- All of them did much worse than the momentum portfolio. In fact, this portfolio has done a way better job than SPY: for the past 5 years, 4.8% annually better and for the past 3 years, 7% annually better!
We attribute the outperformance to the following three factors: 1) factor ETFs can outperform in a long period of time; 2) momentum based rotation can improve returns dramatically; and 3) tactically reducing stock exposure during a market stress can further avoid big loss and improve returns.
To summarize, factor ETF rotation with tactical stock exposure adjustment can be a very useful improvement over a general broad based stock market index such as SPY or VTI. The three factors behind the improvement are intuitive and have been widely studied and practiced.
Disclosure: I am/we are long IEI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.