Despite a temporary return to normality in 2022, equity factor strategies have experienced performance challenges relative to capitalization-weighted indices for the reason that COVID-19-induced market crash in 2020. Although there are numerous explanations for these challenges, our focus here is on a distinct query:
Is it possible to retain the advantages and economically sound foundation of an element approach to equity investing while aligning the performance of an element portfolio more closely to a capitalization-weighted benchmark?
Before we answer that, let’s take a fast take a look at the disadvantages of capitalization-weighted indices. With capitalization-weighted indices, corporations with higher market capitalizations receive a better weighting within the index. On the opposite hand, smaller corporations, which presumably have the best growth potential, receive a lower weighting. Investing in capitalization-weighted index strategies involves a triple risk. First, they might suffer losses if corporations with the most important average weights return to lower cost levels. Second, by underweighting smaller corporations, capitalization-weighted strategies can prevent investors from meaningfully benefiting from corporations with the best growth potential. Finally, capitalization-weighted index strategies focus relatively on a small subset of the most important stocks. This lack of diversification goes against a cornerstone of contemporary investing and leaves investors vulnerable to significant downside risk if a number of of the most important corporations within the index suffer large losses.
In contrast, a properly designed equity factor strategy is driven by risk aspects proven to profit investors over the long run. These aspects – value, momentum, size, profitability, investment and low volatility – have been empirically validated by various researchers over several a long time and have a transparent and intuitive economic rationale. Multi-factor portfolios, that are exposed to all six aspects, are likely to be more diversified, lower-volatility investment vehicles in comparison with capitalization-weighted indices and the products that mimic their behavior. While the latter features have proven helpful to factor portfolios, as we have now seen, equity factor portfolios can perform worse than capitalization-weighted strategies in some market environments. The query is: Is there a solution to retain the advantages of factor investing while remaining more aligned with the performance of capitalization-weighted indices?
What should I do?
As we show below, a binary selection between factor-based investing and capitalization-weighted performance will not be mandatory. Although a wholesale move to cap-weighted benchmarks is unlikely to profit investors in the long term, there may be a middle ground: proceed to speculate in an element strategy, but apply tracking error constraints to narrow the performance gap between cap-weighted and “unconstrained” “Reduce benchmarks” factor portfolios over a selected time frame. As our evaluation shows, applying the latter adjustments to an element portfolio has each benefits and drawbacks in each the short and long run.
How do tracking error-restricted factor portfolios behave?
The chart below shows the recent performance differences between a normal six-factor portfolio – where each factor has equal weight – and its tracking error (TE)-restricted variants. If we apply TE constraints, the table shows that the performance difference between the factor portfolios and the capitalization-weighted index becomes significantly smaller. However, the fee that these portfolios pay is around 100 basis points (bps) of additional volatility and a deterioration in downside protection, as measured by the utmost drawdown.
Factor portfolios with tracking error restrictions,
December 31, 2022 to June 30, 2023
| Lid Weighted |
Six factor Same weight |
Six factor Same weight 1% TE goal |
Six factor Same weight 2% TE goal |
|
| To return | 17.13% | 6.04% | 14.70% | 12.38% |
| volatility | 14.44% | 13.10% | 14.05% | 13.72% |
| Sharpe Relationship |
1.01 | 0.27 | 0.87 | 0.72 |
| Max drawdown | 7.43% | 7.90% | 7.51% | 7.61% |
| Relative To return |
– | -11.09% | -2.43% | -4.75% |
| persecution Mistake |
– | 4.65% | 0.98% | 1.95% |
| information Relationship |
– | No | No | No |
| Max. Relative Drawdown |
– | 10.04% | 2.19% | 4.29% |
The sector composition of TE’s controlled portfolios within the table below shows that the heavy underweight to the technology sector decreases significantly in comparison with the usual multifactor portfolio. That won’t be such a giant surprise. Finally, larger technology corporations have been a key driver of the outperformance of capitalization-weighted vehicles in comparison with equity factor strategies.
Sector allocations as of June 30, 2023
| Cap weighed down | Six factor Same weight |
Six factor Same weight 1% TE goal |
Six factor Same weight 2% TE goal |
||||
| Absolute weight | Relative weight | Absolute weight | Relative weight | Absolute weight | Relative weight | ||
| energy | 4.7% | 6.3% | 2.0% | 5.3% | 0.6% | 5.9% | 1.2% |
| basic materials |
2.3% | 2.6% | 0.3% | 2.4% | 0.0% | 2.4% | 0.1% |
| Industrial stocks | 8.8% | 7.4% | -1.4% | 8.3% | -0.4% | 7.9% | -0.9% |
| Cyclical consumer | 12.4% | 11.7% | -1.0% | 12.0% | -0.3% | 11.7% | -0.7% |
| Not- Cyclical consumer |
6.5% | 11.2% | 5.1% | 7.4% | 0.9% | 8.3% | 1.8% |
| Finance | 12.7% | 13.1% | 1.5% | 12.9% | 0.2% | 13.1% | 0.4% |
| Health Care |
14.2% | 17.7% | 4.2% | 14.8% | 0.6% | 15.4% | 1.2% |
| Technology | 34.5% | 21.5% | -15.7% | 31.7% | -2.8% | 28.9% | -5.7% |
| telecommunications | 1.1% | 2.0% | 0.9% | 1.3% | 0.2% | 1.6% | 0.4% |
| Utilities | 2.7% | 6.6% | 4.1% | 3.8% | 1.0% | 4.8% | 2.1% |
Over an extended measurement horizon, the chart below shows that controlling TE hurts long-term risk-adjusted performance by increasing volatility and reducing returns. The information metrics and the probability of outperforming the capitalization-weighted index over different time horizons also deteriorate barely.
Long-term risk-adjusted performance,
June 30, 1971 to December 31, 2022
| Cap weighted | Six factor Same weight |
|||
| default Portfolio |
Standard portfolio THE 1% |
Standard portfolio the two% |
||
| Yearly Returns |
10.22% | 13.10% | 10.95% | 11.63% |
| Yearly volatility |
17.33% | 15.53% | 16.82% | 16.38% |
| Sharpe ratio | 0.33 | 0.55 | 0.38 | 0.43 |
| Max. Drawdown |
55.5% | 50.9% | 54.0% | 53.5% |
| Yearly Relative Returns |
– | 2.88% | 0.72% | 1.41% |
| Yearly persecution Mistake |
– | 4.20% | 1.14% | 2.21% |
| information Relationship |
– | 0.69 | 0.63 | 0.64 |
| Max. Relative Drawdown |
– | 20.1% | 5.8% | 10.7% |
| Outperformance probability (A yr) |
– | 66.89% | 67.71% | 67.38% |
| Outperformance probability (3 years) |
– | 79.42% | 75.81% | 75.30% |
| Outperformance probability (5 years) |
– | 86.94% | 84.62% | 84.44% |
Diploma
Tracking error risk control is an efficient solution to manage out-of-sample tracking error of multi-factor indices and also can help reduce sector deviations of multi-factor indices. We don’t should throw the newborn out with the bathwater.
However, in the long run, aligning the performance of an element portfolio with a capitalization-weighted index could be detrimental to each absolute and risk-adjusted returns. Furthermore, easy capitalization-weighted approaches to equity investing lack the economic and conceptual foundations that may justify their use. Although they will outperform in certain market environments, they wouldn’t have the formula for superior long-term risk-adjusted performance.
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Photo credit: ©Getty Images/Wengen Ling
