Sharpening The Pencil On Factor Funds


In a post about a week ago I made a reference to the conversation happening in the corner of the Twittersphere where I hang out. This week the conversation seemed to focus on multi-factor, smart beta and single factor ETFs. Cullen Roche Tweeted "GSLC, Goldman's very popular multi-factor ETF perfectly proves the problem with diversifying across multiple of factors. Too many factors and you get a portfolio that looks like a market cap index." He was referring to the Goldman Sachs Active Beta US Large Cap Equity ETF (GSLC). says GSLC "tracks an index of US large-cap stocks comprising 4 subindexes: value, momentum, quality, and low volatility."

Cullen's Tweet includes a chart that shows GSLC appearing to lag the SPDR S&P 500 (SPY) since the former's inception which is corroborated by Morningstar but for the last year GSLC is ahead by about a couple of hundred basis points. Eric Balchunas has long been a fan of GSLC and this article from a few days ago lays out his case.

Is Cullen's critique correct? If he is correct, why have ETF providers launched so many of these funds? The cynical answer of course includes the fund companies believing these funds can be profitable for them but I believe the fund companies believe that these funds can help people (or their advisors) build and manage their portfolios.

This is the Morningstar chart of GSLC versus the S&P 500 since its inception.

Balchunas' article address GSLC's overlap with the S&P 500, there's a lot of overlap. If you're interested in GSLC take the time to learn about, even if you're not that interested, take the time to learn about it but it has enough of a track record for me to think that the strategy won't hurt anyone. That is not to say it will ever outperform, I have no idea about that. That description might apply to all of these funds; may or may not ever outperform but won't hurt anyone. To clarify one thing, the next time the S&P 500 cuts in half, SPY will cut in half and any fund that offers a slightly different or very different mix of mostly the same stocks should be expected to have a similar result. That might mean going down 60% in a down 50% world or going down 40% but doing a little worse or a little better in a bear market would not meet any reasonable threshold of harming investors the way that a couple of the inverse VIX products harmed investors/speculators back in February.

The top performing domestic fund I have seen in this context (factor, mutli-factor, smart beta) has been the iShares Edge MSCI U.S.A. Momentum Factor ETF (MTUM). According to there are 38 momentum funds, 27 low volatility funds, 148 fundamental ETFs and so on so you get the idea but here is a chart of MTUM.

MTUM's first couple of years were so-so, clearly not harming anyone and then in the last couple of years it really took off. The last couple years have been very good for well executed momentum strategies. As strong as the last couple of years have been the long term chart reiterates a point I have been making forever which is that no strategy can always be the best, including market cap weighting.

Over the next X number of years where X is the number of years important to your finances, some broad based index strategy (market cap, growth, value, low volatility, quality, momentum, multi-factor) will be the best and then some other broad based index strategy will be the worst, but generally I would expect they'll be pretty close to each other. I would say that I am not sure low volatility funds will do what investors hope when the next bear comes. Again, I don't think they will harm anyone but if someone thinks they will go down less in the next bear and they don't, that certainly will cause disappointment.

The other day I talked about what I think is the way to look at these funds which is no matter what the name of the fund is you need to look under the hood to see what they own so that you understand how much they do and don't overlap with other funds you use and what the sector exposures end up being when funds are combined. Overlapping doesn't have to be bad like the scenario of pairing some broad-based fund with one that takes defensive action like the Aptus Behavioral Momentum ETF (BEMO) that I mentioned the other day. In that instance the diversification is more about the strategies; one fund stays invested and one has a defensive overlay.

Zooming out a little, this is about building portfolios based on fund attributes as opposed to marketing buzz words. To that end, the ProShares suite of funds that track the S&P 500 excluding one sector of which there are four (financials, tech, energy, healthcare) also have a seat at this table. Where you find yourself overweight a sector in a portfolio that just uses broad based funds, the ProShares suite can directly mitigate the risk.

The point here is not to give the answers, there are infinite answers and what is right for one person may not be right for others. Ideally this is more about figuring out what questions to ask when building your own portfolio or if you're an advisor and building portfolios for clients.