New research shows that some funds that use a factor-based construction process may have over- or under-exposure to industries, sectors, countries and other attributes relative to a market-cap-weighted index.
Factor investing (attributes, such as value, that explain how an asset contributes to the expected return and risk of a portfolio) often results in unintentional exposures to industries, countries and even other factors. Some incidental exposures are persistent (such as value’s negative exposure to momentum), while some vary widely over time. Since such unintentional exposures can lead to significant differences in tracking variance and can also enhance or detract from the performance of factor-based investment strategies, investors should understand how neutralizing those incidental exposures will impact performance. For example, while sector neutrality typically reduces the factor’s exposure relative to the total market cap-weighted index, it also reduces tracking variance.
Today, some indexes, such as the Russell Indexes, do not seek sector neutrality, while others, such as the MSCI value weighted Indexes, do. As an example of how factor-based strategies can lead to unintentional exposures to industries, as of August 16, 2021, the Russell 1000 ETF (IWB) had 25% exposure to the technology sector and 14% exposure to financial services, while the Russell 1000 Value ETF (IWD) had exposure of just 10% to technology and 21% to financial services.
John Scruggs contributes to the factor-based investment literature with his study, “Does Neutralizing Style Factors Help or Hurt?,” published in the August 2021 issue of The Journal of Investing, in which he disentangled the effects of global style, industry and region factors. His data sample included the universe of global, large-capitalization stocks (the FTSE All-World Index) over the period 1995-2019. Industry neutralization was accomplished by decomposing the style factor exposures into interindustry components (the result of tilting a portfolio’s holdings toward industries with high factor exposures whereby the stocks within each industry have benchmark weights) and intra-industry components (the result of tilting a portfolio’s holdings toward stocks with high factor exposures while remaining industry neutral). The 23 countries in the investment universe were mapped into one of four regions (North America, Europe, Asia-Pacific ex-Japan, and Japan), and five types of style factors were analyzed (size, momentum, reversal, value and profitability). For the value factor, four metrics were analyzed: earnings-to-price (E/P), book-to-price (B/P), cash flow-to-price (C/P) and forward earnings-to-price (forward E/P). For profitability, ROE and operating profitability were analyzed.
Following is a summary of his findings:
- Incidental exposures varied widely over time.
- Turnover increased only modestly when incidental factors were neutralized.
- The small-size factor had positive average incidental exposures to industrial goods and services and Japan, and negative average exposures to technology and North America.
- Momentum factors tended to overweight North America and underweight Japan.
- The composite value factor had positive average exposures to banks and Europe, and negative average exposures to technology and North America.
- ROE had positive average exposures to healthcare and North America, and negative average exposure to banks and Japan.
- Neutralizing style factor portfolios reduced factor return volatility while maintaining desired factor exposures.
- For value-related and reversal factors, industry neutralization enhanced performance (in terms of information ratio) – valuation ratios can better discriminate between cheap and expensive stocks after industry-related structural issues (e.g., accounting standards, capital intensity, debt structure) are controlled. However, for B/P, industry neutralization had little impact on improving performance.
Investor takeaway
Scruggs’ findings on the impact of sector neutralization highlight the importance investors should place on performing thorough due diligence when making decisions about which funds are best to utilize when implementing factor-based strategies. That diligence should include whether factor-based funds use neutralization strategies when designing their eligible universe. Some fund families (such as AQR) employ industry-neutralizing strategies, while others do not. And some (such as Dimensional) put constraints on how far sector allocations can differ from the market (e.g., 10%).
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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New research shows that some funds that use a factor-based construction process may have over- or under-exposure to industries, sectors, countries and other attributes relative to a market-cap-weighted index.
