Identifying The Right Neighborhood With MSCI Factor Indices
iShares currently have four factor-based ETFs that slice and dice stocks within the US market into four distinct styles, providing investors dedicated exposures to stocks with specific characteristics. The ETFs, each tracking a MSCI index, are:
- MSCI USA Value Factor ETF (NYSEARCA:VLUE)
- MSCI USA Minimum Volatility ETF (NYSEARCA:USMV)
- MSCI USA Momentum ETF (NYSEARCA:MTUM)
- MSCI USA Quality Factor ETF (NYSEARCA:QUAL)
What are each of these styles? The index provider, MSCI provides an explanation on their website:
- MSCI USA Enhanced Value Index: Designed to represent the performance of securities that exhibit higher value characteristics relative to their peers. Value characteristics are defined using three variables: Price-to-Book Value, Price-to-Forward Earnings and Enterprise Value-to-Cash flow from Operations.
- MSCI USA Minimum Volatility Index: Designed to reflect the performance characteristics of a minimum variance strategy applied to the large and mid cap USA equity universe. The index is calculated by optimizing the MSCI USA Index, its parent index, in USD for the lowest absolute risk within a given set of constraints.
- MSCI USA Momentum Index: Designed to reflect the performance of an equity momentum strategy by emphasizing stocks with high price momentum, while maintaining reasonably high trading liquidity, investment capacity and moderate index turnover.
- MSCI USA Quality Index: Designed to capture the performance of quality growth stocks by identifying stocks with high quality scores based on three main fundamental variables: high return on equity (ROE), stable year-over-year earnings growth and low financial leverage.
A Historical Context
How have the factors fared historically? Below is a chart showing the cumulative performance of the various factor indices over the past 18 years, in USD total returns:
Interestingly, all of the factors have outperformed the broader market, as measured by the MSCI USA Index (large + mid-caps). The best performing factor is Momentum, followed by Value, Quality and Minimum Volatility. The table below provides more detailed statistics:
|Index||Ann. Return||Ann. Vol.||Sharpe Ratio||Beta||2008 Return|
|MSCI USA Enhanced Value||8.1%||17.3%||0.41||1.05||-37%|
|MSCI USA Minimum Volatility||7.4%||11.8%||0.48||0.71||-26%|
|MSCI USA Momentum||9.6%||16.6%||0.50||0.94||-41%|
|MSCI USA Quality||7.7%||14.4%||0.43||0.90||-30%|
An investor following a Momentum-based strategy would have generated an annualized return 60% higher than the standard market cap index, while Value was 37% higher. Minimum Volatility and Quality also provided above market returns, at 25% and 7% less risk respectively. From a risk perspective, Momentum and Value exhibited the greatest volatility.
So Where Are We In The Cycle?
Although Momentum is the clear winner over the very long-term, is it a good time to jump into Momentum or Value? In the chart below we show the rolling 3 year annualized excess returns of each of the factors relative to the parent MSCI USA Index. The performance of each factor is clearly cyclical.
Recent observations point to severe underperformance of the Value factor, while Momentum has defied gravity on a trailing 3 year basis. Quality and Minimum Volatility have also been staging a come back too.
Implications for Bottom-Up Investing
If you believe in mean reversion, then one can reasonably point out that Momentum investing have done too well in recent history and are due for a period of underperformance. In contrast, Value's poor showing is beginning to look pronounced and may soon see some light at the end of the tunnel.
To make some sense of these patterns, let's take a look under the hood of both ETFs.
|3 Yr Rtn (% annualized)||P/E Forward||P/B TTM|
|Home Depot (NYSE:HD)||25||20||21|
|Altria Group (NYSE:MO)||25||19||41|
|Alphabet Class C (NASDAQ:GOOG)||26||36||5|
|Alphabet Class A (NASDAQ:GOOGL)||26||36||5|
The Top 10 constituents appears to be growthy names that have performed strongly of late, such as Facebook, Amazon, Starbucks and Nike. Despite their higher growth, these names are not cheap as investors have bid up their share prices. One can reasonably argue that these high flying stocks will fall quicker in a declining market when investors take profit from the best performing names. For the full list of holdings in the ETF, click here.
Now let's take at the Value ETF:
|3 Yr Rtn (% annualized)||P/E Forward||P/B TTM|
|General Motors (NYSE:GM)||5||5||1|
|JPMorgan Chase (NYSE:JPM)||9||9||1|
|Ford Motors (NYSE:F)||1||5||2|
|Bank of America (NYSE:BAC)||5||8||1|
As expected, the Top 10 constituents contains cheaper names that have done poorly, such as companies in the autos (General Motors, Ford) and banks sector (JPMorgan, Bank of America). Will these stocks remain cheap forever? Probably not. Investors will at some point rotate out of expensive names and into cheaper names which are less prone to price risk. For the full list of holdings in the ETF, click here.
As ardent believers of mean reversion, we believe Momentum stocks have run their course and as a group are prone to the pull of gravity. Meanwhile, Value stocks have been beaten up and will likely stage a come back some time down the line. That said, there could be more pain for cheap stocks before sentiment improves.
We believe that investors could position themselves for a value comeback in the following ways
- Market Neutral: For investors seeking less directional exposure to the US market, we recommend a relative value trade by going long the Vanguard Value ETF (NYSEARCA:VTV) and shorting the iShares MSCI USA Momentum ETF . VTV is significantly more tradable than the iShares MSCI USA Enhanced Value ETF while providing a similar exposure. VTV is also cheaper.
- Directional: For long-only investors, we recommend switching out of broad market exposures (i.e. the SPDR S&P 500 Trust ETF (SPY)) to the Vanguard Value ETF , which represents the less expensive segments of the market that have not run-up as much. Alternatively, investors can also buy a smaller basket of stocks represented within the value ETFs. We believe financials are particularly interesting right now as a long-term play, given their sensitivity to rising rates over the next few years.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.