ETFs continue to play a highly disruptive role in money management. RBA has embraced this trend by employing what we refer to as Pactive™ Management, which is the active allocation, whether strategic or tactical, of passive investment instruments such as ETFs, stock baskets, and index funds. These Pactive™ portfolios have quickly become the fastest growing part of our business.
We have refuted the concerns of some critics of ETFs, however, we join some of the naysayers when it comes to “Factor ETFs.” Our research suggests that Factor ETFs’ actual sources of returns often have little, if anything, to do with the factor* included in the ETF name (i.e., value, growth, or size).
* Factor as defined by a leading risk model provider
RBA’s approach to ETF management is quite different from that of most ETF managers. Our clients’ portfolios typically contain
10-20 ETFs, but internally at RBA we manage the portfolio using the underlying holdings of the ETFs, i.e., as though our portfolio had hundreds or even thousands of securities. When searching for a new ETF, RBA looks beyond basic characteristics like management fees, liquidity, etc., and searches for ETFs that best fit with the existing ETFs in the portfolio while aiming for certain overall portfolio-level exposures. Those exposure goals might relate to size, style, sector, geography, quality, yield, etc.
We call this process of managing ETF portfolios via the underlying holdings “X-Raying” the ETFs, and our x-ray analyses have become increasingly important as the number of ETFs has multiplied. Because there are now so many ETFs from which to choose, our analyses have had to become more sophisticated to ensure that our clients’ portfolios are structured as closely as possible to the desired targeted exposures.
Issue #1: The Cyclicality of Factors
While at Merrill Lynch in 1991, we began publishing Quantitative Profiles. The “QP,” as it was known, was ground breaking at the time because it was the first widely published research that examined the cyclicality and efficacy of various stock selection strategies and factors. This research led to a book called “Style Investing – Unique Insights into Equity Management” (John Wiley & Sons, 1995), which was the seminal book regarding the timing of styles and factors.
Our research clearly determined that styles and factors were highly cyclical, and that one’s portfolio could have significant periods of underperformance if one naively invested in one side of a style decision (e.g., small versus large capitalization stocks).
Investors in today’s Factor ETFs must be cognizant of the potential cyclicality of factor performance, and need to fully understand how the macroeconomy can influence a particular factor’s performance and for how long.
Issue #2: Are the potential returns of Factor ETFs driven by the named factor?
One would think that a Factor ETF’s performance would be driven by the factor advertised in its name. Our proprietary research shows that most factor ETFs are hardly pure investments in the named factor. Worse yet, the specific named factor often had little influence on a Factor ETF’s sources of potential return.