Simply put, quality factor portfolios tend to capture more of both the market upside and downside than low volatilty counterparts, according to Holly Framsted, head of factor ETFs for BlackRock. Quality portfolios tend to feature stocks with strong balance sheets, high returns on equity and consistent, highly predictable profitability. Minimum volatility mutual funds and ETFs, in contrast, tend to focus on trading dynamics and sport stocks with the lowest market betas.
Both strategies often feature dividend-paying stocks, offering income to yield-starved investors while smoothing the ride, Framsted adds. If, as many believe, the expansion is late cycle, low volatility’s relatively strong performance should come as no surprise.
High volatility stocks tend to be lower quality, while low-volatility stocks may or may not be, according to Mike Hunstad, head of quantitative strategies at Northern Trust Asset Management. The author of a paper on factor inefficiency, Hunstad has examined why the performance of factor funds varied so widely in recent years. He has developed a factor efficiency ratio that takes a fund’s risk exposure to the intended factor and divides it by the risk exposure to all factors.
Low-vol’s strong performance in this and other cycles flies in the face of Nobel laureate William Sharpe’s capital asset pricing model, which contends that the only way to improve returns is to increase risk. After all, Hunstad notes, 70% of equities’ return over the last century is attributable to dividends, and income stocks on average have less risk. “There are other forms of systemic risk besides beta,” he explains.
Yet why was the variance of low-vol factor funds so widely dispersed last year? One reason was that some had excessive exposure to interest-rate-sensitive sectors like utilities, REITs and consumer staples. As rates climbed, many stocks in these sectors got crushed, though some have rebounded smartly this year.
Hunstad has another theory. Many factor funds are poorly designed and take unforeseen risks by overweighting sectors, countries and currencies. “If you are not careful, you are taking a lot of unintended risk,” he argues.
Sector neutrality, in his opinion, is the best way to minimize unintended risks. Maintaining sector weight similar to the benchmarks avoids this problem. But many believe the more stringently a fund adheres to sector neutrality the greater the odds that it tracks the overall market.
BlackRock’s Framsted thinks a factor strategy can make sector bets, but investors need to understand them. With quality strategies, most of the metrics employed by institutional investors tend to lead funds to favor companies with low leverage. That can tilt a fund toward certain technology companies and away from financials.
But one can find “quality within each sector,” she adds. Indeed, there are banks with fortress balance sheets, though many financial companies that meet quality factor screens are often service- or transaction-driven like the big credit card concerns.
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