Cyclical rally reveals flaws in some factor ETFs

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The cyclical rally of the past half-year may have reignited the debate on value stocks, but it has also had a ripple effect on other styles of investing. Having already fed the associated editor Algy Hall’s premier action screen, a value slant in momentum strategies has now become evident among funds such as iShares Edge MSCI USA Momentum Factor Ucits ETF (IUMO).

The recent semi-annual rebalancing of this exchange-traded fund has sharply diverted it from the pillars of growth in favor of cyclical stocks. Microsoft, Amazon and Apple all left the fund, being among its top 10 holdings before the rebalancing. The fund’s allocation to financials, meanwhile, fell from just 1.5% of its assets before rebalancing to 32.5%. And its allocation to information technology stocks fell from 41.1% to 17.7%.

The semi-annual rebalancing means that the ETF should be positioned to capture any further gains from cyclicals, which rise and fall in tandem with the economy, although it appears to have missed out on some of the big past returns. So, when you try to navigate the evolution of the markets, you have to determine if factor funds are fulfilling their function. While targeting certain factors can generate outperformance, executing it effectively through funds can be difficult.

This article has already been published by Investor column , a share held by the FT group.

To test this, we looked at how some popular factor ETFs performed under different market conditions. For consistency, we have focused on a range of factor funds offered by iShares.

The last few years have been favorable for many momentum funds, which support market winners and sell losers. IShares Edge ETF MSCI World Momentum Factor Ucits (IWMO) significantly outperformed conventional MSCI World trackers in the five years leading up to June 2, 2021, with iShares Edge MSCI Europe Momentum Factor Ucits ETF (IEMO) clearly beating an MSCI Europe non-UK tracker during the same period.

The iShares Edge MSCI World Momentum Factor Ucits ETF has beaten its conventional counterpart five of the six full calendar years since its launch. The iShares Edge MSCI Europe Momentum Factor Ucits ETF has done the same in three of the four full calendar years since its launch. And the iShares Edge MSCI USA Momentum Factor Ucits ETF has beaten an MSCI USA tracker in three of the full four calendar years of its existence.

Yet, as we noted in Style wars, this approach also plays a large part in the sustainability of the success of market leaders, which can adversely affect the returns of a fund that does not rebalance frequently.

Until its rebalancing, the iShares Edge MSCI USA Momentum Factor Ucits ETF held large stakes in names like Tesla and the Faangs – Facebook, Amazon, Apple, Netflix and Alphabet. But he had little in the cyclics, explaining his underperformance during the cyclical rebound that followed the announcement of the Pfizer-BioNTech vaccine. Between November 9, 2020 and June 3, 2021, the iShares Edge MSCI USA Momentum Factor Ucits ETF achieved a total return of 5.3%. This puts it behind conventional market trackers and value funds.

Other disappointments may still be due. If the cyclical recovery continues, the iShares Edge MSCI USA Momentum Factor Ucits ETF may well benefit. But if most of the cyclical recovery has already taken place and growth pillars like the Faang are expected to rebound, a dynamic fund could miss out on the bigger gains.

The value finally benefited from a further rebound, and factor ETFs certainly benefited from this rise. But investors should ask themselves if value funds are the best way to make gains in an industry. The same reasoning can apply to quality funds, where more direct exposures can generate larger gains.

Matt Brennan, head of passive portfolios at brokerage AJ Bell, tends to favor sector ETFs over factor funds for two reasons. Sector funds tend to be less expensive than factor ETFs and, perhaps more importantly, he sees sector funds as a more direct play on an investing style.

“They often give you better exposure to the factor, because factor-based ETFs are industry neutral in many cases and therefore only tilted. [to] rather than a total value, ”he said. “Using a Banking, Energy and Travel & Leisure ETF will give you more in-depth exposure to the value factor without having to allocate so much and pay so much. “

This emphasis on sector neutrality can be seen in iShares Edge MSCI USA Value Factor Ucits ETF (IUVL). At the start of June, its largest sector weighting was a 26.8% allocation to information technology. Financials represented only 11.7% of the fund and energy only 2.7%.

Sector funds have been the most obvious winners in the cyclical rally since November. The iShares S&P 500 Energy Sector Ucits ETF (IEUS), which achieved a total return of almost 60 percent. Active funds focused on sectors such as energy and financials also made significant gains.

It should be noted that more targeted sector funds can also register larger losses in difficult times. The iShares S&P 500 Energy Sector Ucits ETF fell 22.5% in the three years to June 3, compared to a 27.8% gain for the iShares Edge MSCI USA Value Factor Ucits ETF.

There is a mixed case for funds with minimum volatility. Performance data from February 20 to March 27, 2020, a period that captures most of the initial pandemic liquidation, shows iShares minimum volatility products have suffered smaller declines than conventional indices, especially market products. emerging and global. But they have also fallen behind conventional trackers and other factor ETFs in the cyclical rally. ETF iShares Edge MSCI World Minimum Volatility Ucits (MVOL) only returned 1.8%, compared to a gain of 11.6% for the conventional tracker MSCI World.

While investors may want a smoother ride, the performance of these products demonstrates that mitigating risk can limit your returns both in good times and in the longer term.

* Investors Chronicle is a 160-year-old Financial Times publication providing expert, independent insight into the investment market. It provides educational features, investment commentary, practical advice, and personal finance coverage. To learn more, visit chronicleinvestisseurs.fr

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