The follies of factor fund investing

Investors using smart-beta strategies must remember risks and trade-offs that come with specialized exposure

The follies of factor fund investing

Smart-beta funds, which tilt away from the broader stock market to favour certain factors, are supposed to outperform over the long term. But in the short-to-medium term, they can still underperform– and this year has been a case in point.

Citing data from Morningstar, a recent article by the Wall Street Journal reported that over half of smart-beta funds have trailed their benchmark this year through October, with the category dropping 6.76% just as the S&P 500 rose 8.66%.

“[T]his year, the funds have been hurt by their tendency to be dominated by small-cap and midcap stocks, which has meant they haven’t been as resilient as the overall market during the pandemic and lockdowns,” the Journal said.

It’s been a harsh lesson for many investors. While many smart-beta funds may claim the ability to generate excess returns of about 2% to 3% consistently by selecting stocks with certain attributes, they can be particularly susceptible to market cycles. Their bias toward smaller names also means that factor strategies don’t necessarily have exposure to the heroes of the broader stock market.

“Some of these funds are chronically underweight to or have no investment in market darlings like the FAANG stocks,” Ben Johnson, director of passive strategies and ETF research at Morningstar, told the Journal.

With fewer stocks in their underlying portfolios, many smart-beta funds are also more prone to volatility compared to the broader equities market. That means compared to those in index-tracking funds, the average smart-beta investor should be prepared for more spikes and plunges in their portfolio’s performance.

While factor ETFs may offer a middle ground between passive ETFs and active strategies, the fees for some can be uncomfortably close to actively managed funds. Investors who want to execute a multi-factor strategy using a raft of single-factor funds may also lose out as compounding fees undermine the beyond-market gains they hope to capture. Multifactor funds can represent a way out of that, but investors would do well to scrutinize the performance and cost details of a given fund.

Another potential issue comes from strategies whose claim to outperformance rests on factors outside growth, value, and others that have been established through academic research. A manager may profess to have discovered a new property that drives long-term outperformance, but base their findings on historical backtests that can fail in the real world.

To curtail that risk, John West, a partner at Research Affiliates, suggested that investors look at results based on live trading. If the results that bear out come close to what backtests suggest, they can be more confident that the manager is really onto something.

Finally, the decision to invest in a given smart-beta fund should be driven by a specific purpose. Rather than a high-conviction core holding, many professionals consider such strategies to be more appropriately used as satellite diversifiers, which spares investors much of the heartache that comes when the funds they invest in trail the market, or fall out of favour for years.

“There are some benefits to having a non-cap-weighted strategy in the portfolio during periods of market uncertainty,” said Omar Aguilar, chief investment officer of passive equity and multiasset strategies at Charles Schwab Investment Management.


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