Finding Smarter Beta: Momentum, Quality, And Low Volatility

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Includes: ACN, BR, CHRW, COST, EL, FFIV, INTU, JKHY, MA, MTUM, NKE, PGR, QUAL, ROST, SIZE, TXN, USMV, V, VFC, VLUE
by: Left Banker

Summary

I review the performance records of five iShares smart beta ETFs.

I've identified those stocks that are held in the three top-performing funds.

The results generated a list of sixteen stocks with high potential to provide alpha derived from exposure to a combination of momentum, quality and low-volatility factors.

Finding Smarter Beta

Some time back I wrote a series of articles on mining the holdings lists of factor or smart-beta ETFs as a screening tool. The objective was to pull out a set of stocks that met criteria for multiple premium factors.

There are five well established premium factors: momentum, size, low volatility, value and quality. Each has funds devoted to exploiting those factors. These have come to be called smart beta funds. I reasoned that screening for stocks that appear in the holdings of multiple funds focused on different premium factors would provide a list of names well worth further analysis. One concept could be to construct a small, focused, multi-factor portfolio that would emphasize stocks that were already selected for potential alpha from each of several risk premia.

I've chosen to use the iShares suite of smart beta funds which have been very successful in generating alpha from their criteria for selecting stocks. The funds are rebalanced twice yearly, so it would be a straightforward exercise to revisit the holdings coinciding with those semi-annual rebalancings and update the portfolo.

I settled on using three of these funds. These are focused on low volatility (iShares MSCI USA Minimum Volatility ETF - USMV), momentum (iShares MSCI USA Momentum Factor Index ETF - MTUM) and quality (iShares MSCI USA Quality Factor ETF - QUAL). I last looked at this approach two and a half years ago.

Readers had noted that I did not include two other strong premium factors, size and value. In part, this is because there are simply too many funds that cover those factors, each with its own approach. But if we were to look strictly at the iShares smart beta lineup we could include size, iShares MSCI USA Size Factor ETF (SIZE) and value, (iShares MSCI USA Value Factor ETF (VLUE). At the time, I found that neither of those two were as effective at exploiting factor premia as the momentum, quality and low volatility ETFs. Using three funds gives a small, but diversified number of results. In the following set of results, I've identified a potential portfolio of sixteen names. If I add VALU, no company's stock appeared in more than three funds and the number with three hits expands to 28. I'll discuss those additional twelve in a follow-up article.

To illustrate why I prefer the three I've used here, let's go back five years to the youngest fund’s inception and look at the full performance records (August 2013 to August 2018):

VLUE and SIZE continue to lag the other three, but not by as much as they had the last time I wrote on this topic in 2016. More significantly in my view, MTUM and QUAL beat SPY and USMV comes close enough to make us want to look at its other metrics to help decide on whether to continue to include it, while the other two add no alpha.

I like using low volatility to temper some of the volatility risk inherent in momentum category, so on that qualitative basis, so I lean to continuing with USMV. Key quantitative metrics tend to support that bias. Noteworthy in this context are the worst year and maximum drawdown numbers, which shine for USMV, and USMV's Sharpe and Sortino ratios, which lag only those of MTUM.

If we compare performance for all five of the funds equal-weighted (Portfolio 1 in the next table), the top three—MTUM, QUAL and USMV—equal weighted (Portfolio 2 in the table), and SPY (Portfolio 3), we see that the smart beta approach has been quite successful, and that using only those top three funds is meaningfully more successful.

For each of these metrics, with the trivial exception of portfolio 2’s slightly higher standard deviation, the MTUM-QUAL-USMV portfolio excels, turning in better returns with less downside risk.

So, I’ll stick with using those three funds as a filter. One might argue that the bull market of the period under consideration was largely driven by momentum names and momentum's turn in the spotlight may be ebbing. I would agree, but I see no indications that momentum’s leadership position in the market is at risk any time soon. That view is borne out by narrowing the look-back time to the past twelve months:

As we see the Momentum, Quality, Low-Volatility portfolio (Portfolio 2) has continued to outperform, although if we look at the assets individually we see that VLUE has moved ahead of USMV for the past twelve months:

With that in mind, let’s look at those funds that are held in MTUM, QUAL, and USMV, illustrated by the asterisk in this Venn diagram.

There are 16 stocks in that group:

  • Accenture PLC A (ACN)
  • Brown-Forman Corp Class B (BFB)
  • Broadridge Financial Solutions Inc (BR)
  • C.H. Robinson Worldwide Inc (CHRW)
  • Costco Wholesale Corp (COST)
  • The Estee Lauder Companies Inc Class A (EL)
  • F5 Networks Inc (FFIV)
  • Intuit Inc (INTU)
  • Jack Henry & Associates Inc (JKHY)
  • Mastercard Inc A (MA)
  • Nike Inc B (NKE)
  • Progressive Corp (PGR)
  • Ross Stores Inc (ROST)
  • Texas Instruments Inc (TXN)
  • Visa Inc Class A (V)
  • VF Corp (VFC)

This table shows sectors, size, some recent returns and current P/E ratios for the companies.

The ETFs are rebalanced in May and November. If one had contructed a portfolio comprising these sixteen names as an equal-weighted portfolio at the time of the last rebalance, it would have gained 14.6% through the end of August against a gain of 10.3% for SPY.

Two of the stocks (BF.B and EL) were losers for the period, while thirteen of the sixteen posted double-digit gains. The charge was led by JKYY with a 33.02% gain and BR which posted 26.45%.

As one might expect from a list of assets derived from a screen that includes momentum, the current valuation are high. We see that clearly in their current prices relative to the 52-week highs.

Some might consider these stocks unsuitable to buy at their present valuations. But when I ran this screen in the past and went back to see how the funds that were identified had performed, they consistently beat the broad market benchmarks (see earlier articles cited above for documentation).

Although I was intrigued by the strategy of investing in companies that were found in all three of these ETFs, transaction costs for a portfolio of this size was a drag on implementing the strategy. Several readers had reported that they did and were pleased with the results but, as I recall, they had special, free-trade deals.

Another approach might be to use Motif Investing where an investor can define a portfolio (called a motif) and invest in the entire portfolio for a single commission charge, creating, in effect, one's own passively managed fund. The passive rule being inclusion in all three of the cited smart-beta ETFs. There is a friction cost beyond the commission as one is placing straight market orders to be filled at the next day’s open, but most of these funds have reasonably tight bid/ask spreads so losses to the spread may be tolerable. I’ve not used the site, so I can't comment on how efficient it is on filling orders at reasonable prices.

I understand that Motif Investing has a mechanism for rebalancing, so one could rebalance the portfolio with each semi-annual rebalancing of the source ETFs. I’m considering having a go at creating a motif on the site and investing in what I had been calling the MQLV (Momentum, Quality, LowVolatility) portfolio using their approach. I'd appreciate hearing from any reader who has had experience with Motif Investing. How did that work out for you?

Regardless of how I proceed now, I’ll be reviewing this strategy for performance and a revised set of assets when the funds next rebalance and report on it here. That may be the best time to begin an investment in the MQLV portfolio.

And, finally, I’ll note that even an investor with no interest in the results of this exercise may be well served to review the results of the ETFs shown at the top of this article. Taken together as equal-weighted portfolios of either my three preferred funds or even all five, they have been successful at adding alpha by exploiting their factor premiums.

Disclosure: I am/we are long COST, MA, MTUM, NKE, QAUAL, USMV, V.

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.

Additional disclosure: I am not an investment professional and nothing I write here should be taken as professional advice. Everyone's personal situation is unique. It is the role of finance professionals to provide advice in the contexts of an individual's personal situation. What may be right for my investment goals and risk tolerances may well be quite wrong for someone else. Do your own due diligence. Consult with professionals on your own needs, objectives and tax circumstances before you invest. I do not give advice and ask that readers refrain from asking for it.