reliably produce alpha. “It has to be
something that is backed by intuition,”
“Value is incredibly intuitive —
it makes sense. Buy things that are
priced at less than what they’re worth.
They have to be vetted by academics and practitioners. If there are two
that have passed the test, I’d argue
that they are value and momentum,”
If beta represents the rational reason
investors in an efficient market should
be rewarded for taking risk, investor
sentiment represents an equally powerful explanation for
alpha-generating opportunities that is backed up by hundreds
of investment research studies. This is because individual
stocks and sectors of stocks tend to go through periods when
they are beloved by emotional investors who bid their price
above fundamental values.
Johnson believes that both risk-based and behavioral stories
can “bolster an investor’s confidence that the factor will continue.” Investors often fall in love with the newest hot sectors
or glamour stocks they’ve heard about on the news or at the
“Our monkey brains kick in,” notes Johnson. If a large
enough percentage of investors are using their monkey brain
to pick stocks, this leaves opportunities for those who can put
on their blinders and use their “Vulcan” brain to stick with
boring, underappreciated investing opportunities.
One problem with traditional indexing is that periodic
sentiment-driven episodes force indexes to overweight overvalued stocks. Technology stocks made up one-fifth of the
S&P 500 during the dotcom bubble of 1999, and Cisco alone
made up 4%.
“Why would I want to buy more and more of a company as it
gets more expensive?,” asks Feyerer. “Investors who are using
traditional market-weighted strategies are making a huge bet
in overvalued sectors. Indexes weight on price. Investors are
getting full exposure to the whims of the market.”
Stock investors looking for higher returns on their equity
portfolio can simply invest in higher beta stocks according to
the traditional capital asset pricing model. This is especially
true if they are unable to secure the leverage needed to ramp
up the risk of a market portfolio.
Investors also may be attracted to stocks that are more
likely to blow up in the future. (Who doesn’t want to win the
lottery?) This increases the price of higher beta stocks, lowering the premium investors otherwise would have expected for
taking more risk.
One easy way to avoid stocks that emotional investors
love is to sort out higher beta and more volatile securities.
Historically, less volatile investments and lower beta stocks
have produced comparable or higher returns than higher beta,
more volatile stocks with a lower standard deviation. This
means a higher Sharpe ratio and a consistent alpha.
Investors also tend to underreact to new information. When
Tesla loses an important tax subsidy, investors feeling high
on the company’s prospects may want to deny its impact on
Prices tend to react to this information over time as it is fully
absorbed by the traders, resulting in what is referred to as the
momentum effect. Johnson notes that “we underappreciate
changes in fundamentals,” and trading on momentum can help
boost alpha over time.
Is it more sensible to buy a collection of ETFs that each capture a specific factor or to combine factors into a single ETF?
In addition to the practical convenience of combining factor
funds into a single investment, a new crop of multifactor ETFs
may give advisors an added edge by adjusting factor exposures
to more effectively capture alpha over time.
Dynamic Factor ETFs
The next generation of multifactor ETF strategies can use in-depth research on factor performance during various historical periods to readjust allocations. “Generally, when you look
at the factors individually, you’ll see that they tend to have certain market environments that they tend to like,” notes Feyerer.
Value stocks seem to perform better when interest rates are
rising, and the momentum factor is most valuable in expansionary periods. Dynamic ETFs, such as Invesco’s Russell
1000 Dynamic Multifactor ETF, dynamic multifactor strategy
will shift allocation among multiple factors based on current
“When you take a look at factors that have been historically rewarded, and you look at the correlations of these factors, they have been historically low to negative,” according
“Investors who are using
strategies are making a
huge bet in overvalued
sectors. Indexes weight on
price. Investors are getting
full exposure to the whims
of the market.”
—John Feyerer, senior director of
Equity ETF Strategies at Invesco