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Factors cyclicality: Buckle up; it could be quite a ride!

26 December 2018 | Investing

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Commentary by Doug Grim, a senior investment strategist with Vanguard Investment Strategy Group in the United States.

Have you ever ridden a roller coaster in the dark? You probably felt confident you would feel good when the ride was over but knew to expect some stomach-churning periods along the way. Since it was dark, you couldn't know when those tough moments would come, how long they would last or how dramatic they would be. Your job was just to not panic and hold on.

Rules-based ≠ lower risk

Roller coasters usually come with padded steel bars that lock and protect the rider. But be aware that factor funds, just like traditional active funds, do not come with similar safety features. A common misconception is that equity factor-driven funds are universally more "conservative" than traditional active funds when it comes to performance variability relative to broad market-cap-weighted indexes over short periods of time. That's because many equity factor-driven funds are transparent, rules-based and track an index.

What is often overlooked is that a lot of active decisions feed into the design of different indexes and active factor strategies that can drive materially different performance. Assessing these differences will help shed light on how bumpy or smooth the roller-coaster ride may be for your clients. After all, they will want to know ahead of time if the roller coaster you're strapping them into could come with loops, corkscrews or pretzels. The charts below demonstrate that relative performance variability of U.S. equity factor-driven funds can be just as large as that of traditional active.

Relative performance of equity factor-driven funds can be similar to that of traditional active

Source: Vanguard calculations, based on data from Morningstar, Inc.
Notes: The returns for factor-driven funds are based on conventional and exchange-traded U.S. equity funds from the strategic beta category of the Morningstar database. For a definition of what funds Morningstar classifies as strategic beta, please see: https://corporate.morningstar.com/US/documents/Indexes/Strategic-Beta-FAQ.pdf.
We excluded sector, thematic, leveraged and micro-cap funds to focus the comparison on more diversified fund options. Funds were assigned a proxy benchmark based on the Morningstar investment-focused market-capitalization designation. The proxy benchmark for large-cap-focused funds was the MSCI US Large Cap 300 Index through January 30, 2013, and the CRSP US Large Cap Index thereafter; for mid-cap-focused funds, we used the MSCI US Mid Cap 450 Index through January 30, 2013, and the CRSP US Mid Cap Index thereafter; and for small-cap-focused funds, we used the MSCI US Small Cap 1750 Index through January 30, 2013, and the CRSP US Small Cap Index thereafter.

Be ready for a bumpy ride

Although traditional active funds have tended, on average, to exhibit slightly wider differences from market-capitalization indexes, many traditional active funds have demonstrated lower relative performance cyclicality than certain factor-driven funds. Therefore, the reality is, the roller-coaster ups and downs for some equity factor funds can be as large as—or larger than—some traditional active strategies.

When it comes to putting clients' assets in equity factor funds, a critical task is for you to act like the ride attendant with the measuring stick. Some clients need a ride appropriate for their risk tolerance. Others may simply need their expectations properly set in advance. Your job is to explain that there will be unpredictable ups and downs along the way (as funds out- and underperform the broad market), all while making clients feel confident that the long-term outcome will be worth the ride.

Be sure to assess what performance cyclicality is reasonable to expect for the equity factor funds you are considering for clients. Factor funds are not a more conservative form of traditional active funds; indeed, their variability of performance may look similar. Therefore, you may need to prepare your clients for something much more important than a roller coaster in the dark.

I would like to thank my colleague Ryan O'Hanlon for his contributions to this article.

Important information:

The views expressed in this material are based on the author's assessment as of the first publication date (October 2018), are subject to change without notice and may not represent the views and/or opinions of Vanguard Investments Canada Inc. The author may not necessarily update or supplement their views and opinions whether as a result of new information, changing circumstances, future events or otherwise. Any "forward-looking" information contained in this material should be construed as general investment or market information and no representation is being made that any investor will, or is likely to achieve, returns similar to those mentioned in this material or anticipated in this material.

This material is for informational purposes only. This material is not intended to be relied upon as research, investment, or tax advice and is not an implied or express recommendation, offer or solicitation to buy or sell any security or to adopt any particular investment or portfolio strategy. Any views and opinions expressed do not take into account the particular investment objectives, needs, restrictions and circumstances of a specific investor and, thus, should not be used as the basis of any specific investment recommendation.

This material does not constitute an offer or solicitation and may not be treated as an offer or solicitation in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.

While this information has been compiled from sources believed to be reliable, Vanguard Investments Canada Inc. does not guarantee the accuracy, completeness, timeliness or reliability of this information or any results from its use. Information, figures and charts are summarized for illustrative purposes only and are subject to change without notice.

All investments, including those that seek to track indexes, are subject to risk, including the possible loss of principal. Diversification does not ensure a profit or protect against a loss in a declining market.

In this material, references to "Vanguard" are provided for convenience only and may refer to, where applicable, only The Vanguard Group, Inc., and/or may include its affiliates, including Vanguard Investments Canada Inc.

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