Andrew’s Angle

The Latest Trends in Factors

Mar 4, 2021

The capacity of factor strategies appears large 

Factors are broad and persistent drivers of returns—value, momentum, quality, size, and minimum volatility. The fact that they’re long-term performance drivers doesn’t stop us from adjusting factor portfolios in the short run, and we continually evolve the way we implement factors.

What are our current trends for factors? At the start of the year, my colleague Michael Lane, Head of US Wealth Advisory iShares, and I caught up to discuss the factor industry trends we observed in 2020, new research, as well as expectations for 2021.

Andrew: iShares Factor ETFs continued to gather assets despite challenging performance for several factors in 2020. If interest is not driven by performance, what, in your opinion, has driven increased client investment?

Michael: There are periods of time where specific factor premiums such as small size and value will experience underperformance relative to their counterparts, large size and growth. During those periods of time, like we’ve experienced for several years prior to late 2020, what I heard from advisors wasn’t that they were losing faith in the efficacy of the risk premium these factors will experience over time—they know that these are long-term drivers of returns, but rather they were looking for more efficient ways to execute them in client portfolios.

As a result, investors are increasingly using factor ETFs, including iShares, as tax efficient, low cost tools to capture factor exposure. They are increasingly being used as building blocks to replace what are often more expensive active strategies that may offer less factor exposure. We are seeing many advisors also evolve their portfolios to instill varying degrees of factor exposure, creating more models to allow for more customization to the individual client needs. And, we are seeing more blend factors with index and alpha strategies to build portfolios that have characteristics that will afford them the ability to cater the degree of factor exposure to the willingness of a client to look different than the market.

Andrew: I like that – we can use factor ETFs to replace underperforming, more expensive active strategies and blend factors with index and alpha to construct holistic portfolios that can be customized to client preferences! It’s been very rewarding to see the broader acceptance of Factor ETFs as a low cost, tax efficient way to capture factors. Given the continued interest in factors, how have you seen investors use factors to express market views throughout 2020 and so far in 2021?

Michael: That’s a great question Andrew and one where I’ve seen the most evolution in my 27 years of being a factor investor myself. When I first started investing in factors, alongside many of the early advisor adopters, portfolios began with an index core and from there they used deep factor exposures to “pull” the portfolio to the aggregate factor exposure aligned with the amount of risk the client was willing to take. Then portfolios were developed that were purely factor based with high and low factor exposures, but the use of index funds to capture market beta was largely forfeited. And now, we see a reversion of many advisor portfolios back to creating a core portfolio with factors used as instruments to either express a view of where we are in the economic cycle, or to create a long-term exposure to small size, value, quality or momentum.

A good example of this is how we have observed investors reposition their portfolios for a potential reopening of the economy by allocating to the value and size factors, which for many advisors has been a very painful exposure for many years. But because factors exhibit cyclicality, investors are looking once again to value and size as these two factors have historically outperformed during economic recoveries.

Factor Performance Has Been Cyclical

Chart: Factor Performance Has Been Cyclical

For illustrative purposes only.

During the sharp COVID sell-off in February and March 2020, small cap and value companies suffered as work-from-home and social distancing became the norm. Many of these companies have inflexible business models with large amounts of fixed assets that cannot be easily repurposed for other uses. They tend to generate revenues with in-person interactions and therefore struggled with the sudden socially distanced environment.

But now as the economy moves to re-open, value and size performance has come back reflecting the market expecting in-person interactions to resume.

Factors ETFs and reopening/social distancing themes
Correlation of 2020 daily excess returns (v. S&P 500)

Chart: Factors ETFs and reopening/social distancing themes

Source: BlackRock, Bloomberg, JPMorgan as of 12/31/2020. For illustrative purposes only. "Social distancing winners" and "reopening winners" are represented by stock baskets constructed by JPMorgan. The baskets are comprised of stocks that may potentially benefit from extended social distancing or economic reopening (social distancing winners: JPAMDISO; reopening winners: JPAMDISU). Each basket includes 30-50 stocks which are weighted by liquidity. The numbers in the table represent correlations between the excess returns (relative to the S&P 500 Index) of factor ETFs and the two JPMorgan baskets; correlation is a statistic that measures the degree to which two securities move in relation to each other. Correlations can range from a perfect negative correlation (-100%) to a perfect positive correlation (100%). Correlations are calculated with the daily excess total returns (relative to the S&P 500 Index) of each factor ETF and JPMorgan basket.

As positive vaccine news started to be released in the 4th quarter, we observed an uptick in demand for both value and size. Notably, VLUE, IWM, and IJR had more than $1.25B in inflows each in the 4th quarter of 20201. These inflows indicate that investors are becoming more optimistic on reopening the economy as vaccines continue to be rolled out.

Andrew: Speaking of value, the value factor has suffered terribly over the past few years. At the end of 2020, we started to see a slight comeback. How have advisors communicated to their clients that they should stay invested in value over the long run?

Michael: That’s a great question. Over the long run, value stocks have outperformed growth stocks2. As with all factors, there are periods of times where an individual factor may underperform as we’ve seen recently with value. And while short term underperformance can be disappointing, if you’ve taken the risk of investing in value but haven’t yet been rewarded, staying invested in value may be prudent. This is exactly the dialogue we have seen with many of our advisors, but it has been very important that advisors set the right expectation up front with clients. Risk factors are not a free lunch.

Andrew: Besides size and value, are there any other factors where you’ve seen increased interest in from clients?

Michael: As mentioned earlier, we are once again seeing more clients use a barbell approach within their portfolios, but a new use case of the barbell approach has been complementing value exposure with exposure to the quality factor. The BlackRock Investment Institute recently recommended considering quality stocks to balance out cyclical exposure in their Global Investment Outlook. I couldn’t agree more. In fact, we believe a quality factor ETF, such as QUAL can help balance a value and size overweight in a portfolio. Since QUAL looks at multiple metrics – profitability, leverage, and earnings variability, it nicely complements allocations to more cyclical factors that may provide exposure to more highly levered firms.

Let me turn things around and I’d like to ask you a question… there’s lots of exciting things happening in the factor space in 2021. Andrew, from a research perspective, what are some of the things you and your team are looking at?

Andrew: Thanks Michael. Factors, like any good investment concept, will continue to evolve, and here at BlackRock, we are constantly looking for ways to ensure we remain at the forefront of factor investing innovation. Some areas that we have been researching recently include:

  • Enhancing our measurements of factors – We have long favored using a multiple metric approach to capture factors, as we believe it’s more prudent to evaluate a security through multiple lenses. We shouldn’t be using blunt price metrics invented in the 1930’s for factor portfolios in 2021. We’re continually evolving our process as we look for better ways to capture factors. In our active factor portfolios, we’ve extended value to intangibles, momentum to text-based, machine-learning sentiment, and quality to non-financial measures like corporate culture.
  • Greater ability to tilt towards factors with “factor complements” – When I say “factor complements,” you can think of a mega cap vs small size, and growth vs value. Sometimes, you might use the word “anti-factor”—but as you know, I’m certainly not against factors! In the long run, we want to hold smaller and cheaper stocks. But, in the short term, there are periods where factors underperform their complements. During these periods, factor complements can be rewarded instead of the factors themselves. For example, growth rallies may be justified based on record profitability, innovation, or increased market sentiment. As such, using an unconstrained dynamic factor model that allows tactical weights to “factor complements” can be viewed more favorably at times than using a model constrained to only factors.
  • ESG investing and its ties to factors – The ESG transition in financial markets will have an outsized impact on future investments. Knowing this, we can incorporate ESG directly into our factor definitions as well as lean into factors that have more ESG-friendly characteristics. Our research has found that funds with high ESG scores tend to have significant factor exposures.3 Investors should understand how ESG investing can potentially lead to unintended factor tilts.

Michael: All the new research being done is very exciting, and very important for both existing factor users and those that are still observing and waiting to jump in! I’m looking forward to watching factor investing continue to evolve in 2021 and beyond.

Andrew: Thanks, Michael. It was great to hear from you on how investors are positioning for the first quarter. I look forward to catching up with you again later in the year.

Andrew Ang
Andrew Ang
Head of Factor Investing Strategies
Andrew Ang, PhD, Managing Director, coordinates BlackRock’s efforts in factor investing. He leads BlackRock’s Factor-Based Strategies Group which manages macro and style ...
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