Benjamin Lavine serves as the Chief Investment Officer and sits on the executive management and investment committees at 3D Asset Management. Ben works closely with 3D’s investment committee to refine and enhance the investment architecture underlying 3D’s ETF managed portfolios. We recently spoke with Ben, who will be speaking at our ETF Strategy Summit (Oct. 15 – 16 – Dallas), as he shared his thoughts on how to invest in factors.
ETF Strategy Summit: Since a multi-factor ETF may shift between factor, style and sector exposures as it rebalances, how should advisors think about implementing one within a client portfolio?
Ben Lavine: Most rules-based ETFs will reconstitute semi-annually and rebalance quarterly although some multi-factor ETFs will reconstitute quarterly to account for higher turnover factors such as momentum. Regardless of reconstitution frequency, the underlying factor exposures should not change too significantly over time unless there is a change to the multi-factor model itself. Many multi-factor ETFs also optimize their risk exposures versus a cap-weighted index like the S&P 500 or Russell 1000 Index, so investors can be reasonably assured that they will be invested in a strategy anchored to broad market risks. Hence, multi-factor ETFs can serve as a close substitute for traditional cap-weighted ETFs to provide core market exposures, but the devil is always in the details, so make sure to analyze both basket design and implementation and how multi-factor ETF candidates interact with other components within an investment program.
ETF Strategy Summit: Are there specific factor combinations or blends that investors should try to avoid? Which pairs or combinations make the most sense in today’s market environment?
Ben Lavine: Factor combinations or blends can run afoul of data mining resulting in a model with the best performing factors combined in the best performing manner over the testing period. The ETF provider should be ready to explain the economic or intuitive rationale for, say, why a dividend factor should be combined with a low volatility factor. Most investable factors can be combined into two categories: value and sentiment. Many multi-factor model ETFs will combine factors from these two categories because they have historically blended well resulting in performance where the ‘whole’ is greater than the ‘sum-of-the-parts.’ There is some ongoing debate over whether low volatility is an investable, alpha-generating factor or is better implemented as a risk control. For instance, several multi-factor ETFs use volatility as an initial screen to weed out high volatility stocks from the starting universe before generating factor scores. Some recent multi-factor ETFs use a dynamic approach to time factor exposures based on a backward assessment of fundamentals (i.e. factor valuations) and/or a forward assessment of the economic backdrop with the idea that certain factors perform better depending on the stage of the cycle. If investors believe that we are about to enter a recession, historically, you would have wanted to avoid ‘value’ and increase exposure to more defensive factors such as ‘yield’ and ‘quality.’
ETF Strategy Summit: Does it matter if factors are accessed actively or passively?
Ben Lavine: Probably not, but the ‘rules’ underlying a passive implementation provide greater transparency and more assurance that an ETF will follow its intended mandate. In addition, passive ETF managers will more likely use the basket creation/redemption to minimize realized capital gains distributions so as to minimize the tax impact from periodic rebalancings. On the other hand, active implementation of factors, unconstrained by a tracking benchmark, enables an ETF manager to (potentially) create a basket with more targeted factor exposures versus a passive implementation as the ETF manager can rebalance much more frequently – an important aspect for higher turnover factors like momentum.
ETF Strategy Summit: How has sector neutralization impacted the performance of factor ETFs thus far in 2018? Should advisors seek single factor or multi-factor ETFs that are sector neutralized, or employ more unconstrained factor products?
Ben Lavine: Group neutralization (whether sector, country or even risk buckets) can make a huge difference in factor performance over the short-term such as what was experienced in 2017 when the technology sector ran ahead of the major sectors. In 2018, it’s been a mixed bag for neutralization. The technology sector had been handily outperforming the other sectors throughout the first quarter but then reversed in April when energy and industrial cyclicals took over sector leadership. However, the impact from group neutralization tends to decline over longer periods of time. In addition, group neutralization has generally not worked for sentiment factors like momentum because much of momentum’s performance comes from both sector and stock-specific exposures. On the other hand, group neutralization has worked better for fundamental-based factors such as value. At the margin, group neutralization can help reduce factor volatility by removing group-level effects, but it can also reduce factor efficacy. Advisors should always consider how a single or multi-factor ETF fits within a broader investment program. A factor ETF that does not neutralize groupings may make more sense if it is offsetting group level bets from other strategies held in the program.
ETF Strategy Summit: Are ETFs and strategies that cycle through factors more desirable than factor blends?
Ben Lavine: The jury is still out on the efficacy of factor timing and whether it can produce consistent excess returns versus a static model. Some investors believe that factors exhibit momentum tendencies over a 12-18 month period, similar to the momentum effect at the security level. Others believe that factor exposures should be determined on where we are in the macroeconomic cycle. We believe that there are periods when factors look exceptionally overbought or oversold, but these are infrequent moments at best; hence, investors will probably be better served with a strategic factor blend.
ETF Strategy Summit: Thanks Ben. We look forward to hearing more of your thoughts at the ETF Strategy Summit October 15 – 16 in Dallas.
Justin Sibears is a Managing Director at Newfound Research. He’s responsible for the ongoing research and development of new intellectual property and strategies. Justin also serves as a Portfolio Manager for Newfound’s direct offerings. We recently spoke with Justin, who will be speaking at our ETF Strategy Summit (Oct. 15 – 16 – Dallas), as he shared with us how they incorporate behavioral finance into their investment process.
ETF Strategy Summit: Factors, geographies, sectors, asset classes, styles, strategies – given today’s environment, are there any methods for slicing up the markets with ETFs that are clearly superior to others?
Justin Sibears: We believe it is equally important to view a portfolio through all of these lenses. We have a saying at Newfound that “risk cannot be destroyed, only transformed.” Oftentimes, viewing risk through only one of these lenses may lead us to make decisions that appear to reduce risk, but instead simply shifts the risk in a way that hides it from view.
As example, consider value strategies. Value strategies can be classified in many ways, but one important way is how they manage sector risk. Some value strategies are sector unconstrained. They will pick the cheapest stocks regardless of what sector they are in. Some value strategies constrain their sector allocations to be in line with the broader market. Others may fall somewhere in the middle. It’s entirely possible that two value strategies, one sector unconstrained and one constrained, may quantitatively have similar exposure to the value factor. If we stopped our analysis here, we may miss potential sector exposures that could be problematic. For example, the investor may have a large strategic position in energy stocks and so may not want to own a value strategy that can simultaneously make a large bet on energy.
ETF Strategy Summit: What methods can advisors use to keep abreast of a portfolio’s exposures as they blend things like style, factor and active ETFs with alternative strategies, country ETFs or sector ETFs?
Justin Sibears: We recommend that advisors blend quantitative and qualitative tools. Today, there are many quantitative tools that allow advisors to measure risk and stress test portfolios. These are undoubtedly valuable. However, it’s also important to note that these tools have limitations. They are only as good as the assumptions they make. Relying on quantitative tools exclusively has the potential to lead to over optimization and false confidence. To protect against this, we advocate complementing quantitative analysis with simple qualitative rules-of-thumb. As an example, we think it’s hard to go wrong with equal-weighting exposures, whether that be sectors, factors, or asset classes. As Harry Markowitz, the father of modern portfolio theory, said, “I should have computed the historical co-variances of the asset classes and drawn an efficient frontier. Instead, I visualized my grief if the stock market went way up and I wasn’t in it – or if it went way down and I was completely in it. My intention was to minimize my future regret. So I split my contributions 50/50 between bonds and equities.”
ETF Strategy Summit: You’ve noted that modern portfolio theory is imperfect – how are you incorporating client behavior to optimize asset allocation?
Justin Sibears: At a high level, we incorporate behavioral finance into our investment process by acknowledging that investors dislike losing money more than they like making money. We know that investors care deeply about protecting the capital they have worked hard to accumulate and as a result our first focus is on risk. Specifically, the majority of our strategies seek to improve risk-adjusted returns and manage sequence risk by avoiding large drawdowns.
We also recognize that while investing shouldn’t be complicated, that doesn’t mean that it is easy. In the real world, short-term emotional decisions can threaten even the best-scripted financial plan. As a result, we believe strongly that the optimal investment strategy for any client is, first and foremost, one that they can stick with. This means recognizing that managing client anxiety is paramount for long-term success.
We take a multi-dimensional view of anxiety. Specifically, our optimization process is built around the following three tenets:
- Not risk averse, but loss averse. In modern portfolio theory, volatility is used as the main metric of risk. Investors, however, are not necessarily risk averse. In fact, a 2014 paper by Frazzinni and Pederson finds that investors actually have a preference for high risk, “lottery” style investments. By using volatility as the primary measure of anxiety, modern portfolio theory punishes both bad, downside risk and preferable, upside risk equally. Our process focuses explicitly on downside risk.
- Keeping up with the Joneses. When evaluating outcomes, humans often have an established reference point. Outcomes are classified as gains if they are above the reference point and losses if they are below. In investing, reference points are often established public benchmarks (e.g. the S&P 500), but may also be the performance of peers. Our process considers tracking error as one measure of anxiety. If we are going to make bets that move the portfolio away from the benchmark, we have to be adequately compensated as these bets will inevitably lead to angst during periods of short-term underperformance.
- A preference for a smooth ride. While modern portfolio theory is concerned with optimizing for the end result, investors live in a continuous environment. Behavioral research finds that investors who monitor their portfolios more frequently will actually perceive their investments to be riskier: a phenomenon known as myopic loss aversion. Framing investment results over short investment horizons, compared with an asymmetric view of gains and losses, creates a preference for a “smoother” ride over time. As a result, our process is willing to sacrifice some long-term return for a more enjoyable experience since this can reduce investor anxiety and increase commitment to the investment plan.
ETF Strategy Summit: You’ve also advocated for lowering withdrawal rates as the assumed future rates of return for traditional investments decline – should investors and advisors also become more comfortable with risk taking to achieve their goals?
Justin Sibears: It’s hard to make a credible case for future stock and bond returns living up to past experience. The unfortunate consequence is that financial rules of thumb – like the 4% withdrawal rule – may fail going forward since they were calibrated to the past. One easy solution for retirees is just to withdraw less money. For obvious reasons, this solution is far from ideal, if not impossible for some.
There is no silver bullet for solving this problem. Fortunately, we do believe that there are many marginal improvements that when compounded can get withdrawals back up to acceptable levels. Some of these improvements are more planning than investment centric (e.g. managing fees, increasing savings, being smart about asset location, and using dynamic withdrawal strategies).
On the investment front, we do believe that risk plays an important role. However, it’s not as simple as being comfortable with more risk. When expected returns are high across the board, we have the luxury of making risk profile choices as a matter of personal preference. If we are a conservative person, we can allocate conservatively and vice versa. In our current environment, however, this is no longer an option for many people. Instead, it’s crucial to choose a risk profile that has a realistic shot of delivering on a client’s long-term objective even if this means taking more risk than you might otherwise take in a perfect world.
We also believe that it’s very important to diversify your diversifiers. Low interest rates are so detrimental to retirees because they make the most common risk management tool, bonds, extremely expensive to hold in large quantities. In this type of environment, one way to improve returns is to move beyond fixed income as a risk management tool. This means incorporating other asset classes and strategies that have a proven track record of strong performance in times of financial crisis. One example of an investment style that fits this profile is trend-following.
ETF Strategy Summit: How are you using active and passive products together in a meaningful way in your portfolios?
Justin Sibears: We use active strategies that attempt to harvest the risk-adjusted outperformance of evidence-based factors like momentum, value, carry, and defensive. Generally speaking, these types of strategies can outperform over the long-run for three reasons. First, the outperformance may be compensation for bearing risk. Second, the outperformance may be the result of taking advantage of other investors’ behavioral biases. Third, the outperformance may result from taking advantage of structural inefficiencies in the market.
In all three of these cases, underperformance, especially over the short-run, can and will occur. This underperformance is a necessity for the premium to exist. If it never occurred (i.e. if a premium is compensation for bearing risk and the risk never materializes), too many investors will adopt the strategy, capital inflows will drive up the prices of the underlying securities, and the forward return of the strategy will approach zero.
As an example, investors are broadly aware that value investing has historically generated excess risk-adjusted returns. However, actually capturing this return required suffering through excruciatingly long periods of underperformance (consider that the Barron’s cover article in December 1999, What’s Wrong, Warren?, opined that “Warren Buffet may be losing his magic touch.” The bubble peaked three months later.).
Simply: if we expect to generate long-term outperformance, we must expect periods of potentially short-term underperformance in which weak hands that fold pass the premium to the strong hands that hold. The trick of asset allocation, in our mind, is to make the ride bearable so that investors stand a chance of staying committed to these active strategies so that the benefits can be reaped over the long-term.
We seek to achieve this goal in two ways. First, we seek to diversify both across active strategies (e.g. pairing momentum and value) and within active strategies (e.g. diversifying how our value strategies measure value, think P/E vs. P/B vs. EV/EBITDA). Second, we recognize that this type of diversification may reduce the magnitude and duration of underperformance, but it will not eliminate it. Therefore, we blend passive strategies into the portfolio to manage tracking error. In addition to helping us manage tracking error, the passive component allows us to manage overall portfolio cost to a level that we deem acceptable.
ETF Strategy Summit: Thanks Justin. We look forward to hearing more of your thoughts at the ETF Strategy Summit October 15 – 16 in Dallas.
Joe Smith is a Senior Market Strategist at CLS Investments. He specializes in quantitative research, risk management, and ETF due diligence. We recently spoke with Joe, who will be speaking at our ETF Strategy Summit (Oct. 15 – 16 – Dallas), as he shared his thoughts on the benefits of diversification.
ETF Strategy Summit: In 2017, much was made of the convergence of strong markets around the world. Is the higher volatility and divergence this year signs of a new pattern, or merely an interruption to the general trend of convergence?
Joe Smith: The return of higher volatility has created somewhat of a divergence from the strong trends in markets we saw in 2017. Much of the volatility has clearly translated in a greater amount of dispersion amongst stocks globally. We are likely to continue to see this as both foreseen and unforeseen risks globally play out in markets.
ETF Strategy Summit: Where are the world’s most egregious trouble spots, and, to follow up, are there frontier markets where risk is being significantly mispriced?
Joe Smith: There is no single particular part of the world that doesn’t face some risks associated with their markets. Higher relative valuations in the U.S., global debt levels, and investor emotions in CLS’s view pose the greatest threats to the markets in the near term. We believe that this risk can be managed by being properly measured and managed through a Risk Budgeting portfolio construction approach.
ETF Strategy Summit: In 2016, you argued that U.S. equities were becoming expensive and recommended investors take a more international approach to asset allocation – has that perspective evolved as valuations cooled due to increased volatility and earnings growth?
Joe Smith: At CLS, we continue to believe that despite increased volatility in 2018 stocks overseas represent a better opportunity based on their relative attractiveness due to valuations. International equities have largely provided additional diversification benefits to that of their U.S. counterparts and generally have higher return expectations over the next few years.
ETF Strategy Summit: Is taking a single-country approach to ETF allocation versus a regional, international or global index approach worth the additional expense of time and fees?
Joe Smith: Both approaches can be valuable when constructing globally balanced ETF allocations. Regional allocations can provide greater coverage across markets and generally improved liquidity. Country allocations can be great ways to take advantage of a finer cut of securities trading at more attractive relative valuations. Both approaches can also provide great ways to access unique diversification benefits especially with areas that are generally less correlated with broader market movements.
ETF Strategy Summit: How can investors implement factors across a global ETF strategy?
Joe Smith: If an investor has a desire to implement factors in a simple way within their global ETF strategy, multi-factor ETFs provide an efficient way to gain factor exposure without thinking about how to put multiple factor strategies together. If an investor prefers having a greater sense of control with their factor exposure in their portfolios, single factors are great tools to mix and match which factors an investor prefers to dial-up or dial-down in their portfolio. They key for either approach is that investors stay fairly diversified across factor strategies and take a long-term horizon towards seeing the benefits of factors working for their portfolios.
ETF Strategy Summit: Thanks Joe. We look forward to hearing more of your thoughts at the ETF Strategy Summit October 15 – 16 in Dallas.
Linda Zhang is the CEO at Purview Investments. She specializes in ETF managed solutions, ESG/Impact Investing, ETF research and execution. We recently spoke with Linda, who will be speaking at our ETF Strategy Summit (Oct. 15 – 16 – Dallas), as she shared her thoughts on ESG investing.
ETF Strategy Summit: Recent research has muddied the debate as to whether ESG adds positive or negative alpha to a portfolio – how do you think about this issue?
Linda Zhang: The comparison of ESG investing and traditional investing is often misguided. First, the time horizon issue. At any given period, one may have performance better or worse than the other. Second, the benchmark issue. A clean energy ESG product might be compared with the broad market index. Third, the measurement issue. The benefits of environmental cleanness and social fairness are not counted, as these benefits are often not measurable in financial return terms.
The view, that ESG is just another alpha generation tool, is not complete. ESG investing brings multiple benefits, beyond financial returns. Purview sees positive impact from ESG investing as the third dimension of modern finance – Return, Risk and Impact. Together, they lift and expand the traditional 2D efficient frontier line (return/risk) to a new 3D efficient surface (return/risk/impact). Investors have choices to choose a portfolio on the efficient surface that best combines the dual investment objectives of return and impact, subject to the risk tolerance.
ETF Strategy Summit: While indexes based on ESG scoring are maturing, is this still a space best accessed via active management?
Linda Zhang: Several companies have become leaders in the ESG scoring business. ESG measurement systems have become more accepted and better understood in the investment community. This is a healthy development for both index-based products and actively managed products. Active managers are better equipped with more research tools and data to more informed decisions.
ETF Strategy Summit: Two groups are often associated with ESG investing: Women and millennials – should the industry be proactive about diversifying the ranks of ESG investors with more men and members of other generational groups?
Linda Zhang: A few survey based studies have pointed out women and millennials tend to be open to ESG investing. However, it would be a mistake to assume that ESG investing should only serve women and younger investors. Education is the key to help investors better understand the reasons for ESG investing. The investment community needs to do a better job reaching out to a broad audience by gender, age, geographical and social economic scopes.
ETF Strategy Summit: How do you think ESG investors should approach digital privacy issues faced by companies like Google, Amazon and Facebook?
Linda Zhang: Digital privacy is a corporate governance issue, it’s a business ethics issue. Investors need to follow whether these companies have a comprehensive and sound corporate governance policies regarding digital privacy. Do these companies follow local and global standards? Do they abide by the regulations regarding digital privacy? The recently implemented GDPR in the European Union sets the standards for company practices regarding digital privacy. If ESG investors find that some companies do not meet the investor’s criteria on corporate governance, they should exclude these firms.
ETF Strategy Summit: Can the ETF structure allow managers and investors to more precisely target ESG outcomes?
Linda Zhang: ETF structure is index based. Index providers can design a specific index to target the desired impact along environmental, social and governance principles.
ETF Strategy Summit: Thanks Linda. We look forward to hearing more of your thoughts at the ETF Strategy Summit October 15 – 16 in Dallas.