Employing Factors in a Portfolio's Core

Written by: Larry Whistler, Chief Investment Officer, Nottingham Advisors

When employing core/satellite investment strategies, investors often focus only on low-cost market cap-weighted indices when constructing the core, or strategic, allocation of the portfolio in order not to stray too far from an established benchmark. A willingness to explore non-cap weighted indices, or strategic beta, can often prove valuable in establishing a less volatile, more consistent return profile in the heart of the portfolio.

So-called “strategic-beta” exchange-traded funds (ETF’s) can be loosely defined as any ETF that doesn’t track a market-cap weighted benchmark. Typically, the ETF’s are built around some factor – value, quality, momentum, size or low volatility – or some combination of factors. These ETF’s typically follow a rules-based process for security selection, and often will exhibit very different return profiles than standard market-cap weighted indices.

At the heart of strategic-beta is an adherence to a factor, or combination of factors, with security selection designed to focus on those companies, or groups of companies that best exhibit this specific trait. For example, low-volatility, or minimum-variance portfolio ETF’s, have exhibited unique return profiles over time versus standard market-cap weighted indices, capturing roughly 85-90% of the cap-weighted indices’ upside, and only 70-75% of the downside. This can be a very helpful return profile for conservative investors worried about the risk of loss in their portfolio.

Alas, as with most things in investing, there is no free lunch. Factor outperformance, or alpha, is not assured over shorter periods of time, although academic studies dating back to the well-known Fama-French 3 factor model paper in 1993, have validated the existence of a return premium over market cycles. At Nottingham Advisors, we prefer to “hedge our bets” by including a multi-factor ETF with a single-factor ETF (our bias is towards minimum-variance ETFs), in order to help smooth out the return profile during periods of single-factor underperformance.

An analysis of single & multi-factor return profiles, in conjunction with market-cap weighted exposures, shows varying return profiles over time. In some, volatility is accentuated, while in others it’s diminished. Oftentimes, exposure to the momentum factor can lead to sustained periods of outperformance in up-cycles, and below-average returns during bear markets. Beauty tends to be held in the eye of the beholder.

An example of a blended core is illustrated below, with return data generated from the past five years. The “Factor-based core” includes a single-factor ETF, a multi-factor ETF and a straightforward low-cost market cap-weighted ETF, in equal weights. The “Cap-weighted Core” consists only of the straightforward, low-cost market cap-weighted ETF. As can be seen in the data table below sourced from Morningstar, the Factor-based Core realized greater return per unit of risk, as measured by the Sharpe Ratio (1.42 vs. 1.27) while generating positive alpha over this time period.

As suggested above, strategic-beta ETFs can be used as risk-mitigation tools as well as return-enhancing vehicles. Risk-management ETF’s typically center on low or minimum variance, low or high beta and risk-weighting schemes. Return enhancing ETF’s often employ equal-weighting or revenue-weighting schemes, fundamentally-weighted strategies, value, quality, size, growth or multi-factor approaches. Diligence is required as these vehicles run the gamut from “cheap and effective” to “expensive and useless”. Again, a thorough understanding of what it is you’re trying to accomplish is paramount.

Nottingham sees various strengths and weaknesses in market cap-weighted portfolios. On the plus side, they often provide the cheapest exposure to the broad market and can be highly liquid. To their detriment, it’s in the very nature of a cap-weighted index that an overvalued company can become a greater share of the index at the expense of the cheaper (and thus potentially more attractive) companies in the index.

As we make our way through year 8 of the current bull market, thoughts may be shifting away from return enhancement strategies to risk management schemes. Factor-based ETF’s, or strategic beta, can play an important role in helping protect gains earned over the past decade.

Learn more about Nottingham Advisors here .

Nottingham Advisors, LLC ("Nottingham") is an SEC registered investment adviser located in Amherst, New York. Nottingham and its representatives are in compliance with the current registration and notice filing requirements imposed upon SEC registered investment advisers by those states in which Nottingham maintains clients. Nottingham may only transact business in those states in which it is registered, notice filed, or qualifies for an exemption or exclusion from registration or notice filing requirements.