Factor timing, a historically tricky endeavor, remained that way in 2018. Early in the year, the growth and momentum factors solidified their leadership positions with small caps following suit.
Late in the third quarter, the growth, momentum and small size factors led equity markets lower. In the exchange traded funds (ETFs) space, the first domestic broad market funds to enter bear markets last year were small-cap ETFs. Theoretically, erosion in higher beta trades should have spurred interest in more defensive factors, such as low volatility and value, but as the chart below indicates, timing that move was not easy.
As has been widely documented across academic studies, investment cases and media reports, not only does factor leadership change from year-to-year , but some factors can under-perform for extended periods. A prime example of that is value's laggard status relative to growth during the course of the most recent U.S. bull market.Related: Eyeing Alternatives With A Managed Futures ETFRelated: Why Rules Matter With Emerging Markets Investments
The difficulties associated with factor timing are likely one reason why more advisors and investors are embracing multi-factor ETFs, such as the JPMorgan Diversified Return U.S. Equity ETF ( JPUS ) . Among the various smart beta strategies, only value ETFs added more new assets last year than multi-factor funds. The $15.49 billion allocated to multi-factor ETFs in 2018 was up more than 10% from the prior year and more than triple the inflows to multi-factor ETFs in 2016.Courtesy: Bloomberg
Avoiding The Temptation Of Factor Timing
Just as investors are tempted to time individual securities, usually by attempting to buy low and sell high, there is temptation to time individual factors. Even when the strategy proves successful for an isolated period, it is not risk-free.
“Even if there is a return benefit from factor-timing, implementing it reduces diversification relative to a static multifactor portfolio, which may outweigh the benefit,” said Morningstar in a recent note . “And it's important to bear in mind that even if a timing signal works on average, it won't always get the calls right. There is no pain-free way to beat the market.”
The five widely followed investment factors are growth, low volatility, quality, small size and value. Various multi-factor ETFs use different combinations of those factors. For its part, the JPMorgan Diversified Return U.S. Equity ETF ( JPUS ) screens stocks using the value, quality and momentum factors. Adding to the case for a multi-factor strategy, such as JPUS, is the business cycle. Simply put, some factors perform better at certain stages of the cycle than others, but not all investors are business cycle experts, underscoring the utility of a fund such as JPUS.
“During expansions, as clearly defined trends emerge, momentum has been the best-performing factor,” said Morningstar. “Unsurprisingly, low volatility and quality have tended to do the best during slowdowns.”
Past Performance Isn't Predictive
Another issue with factor timing is that practitioners of the strategy rely heavily on backward-looking data. Academic research indicates that many of the signals that worked for certain factors in select periods can lose efficacy over time. Remember, value has a long history of beating the market, but no one could have foreseen value's long laggard status relative to growth over the past decade.
While factor timing clearly has drawbacks, some market participants will continue giving it a go. Emphasizing one or two factors over the others can reduce portfolio diversification, potentially increasing risk and volatility. The JPMorgan Diversified Return U.S. Equity ETF ( JPUS ) helps investors mitigate those issues.