Times of extreme market volatility can be unnerving for investors, but in stressful times, changing a long-term investment plan can undermine investors' ability to achieve their investment goals. For investors in multifactor exchange-traded funds (ETFs), we believe it’s important to maintain a long-term and consistent focus in turbulent times. The size, value, and profitability premiums targeted by multifactor funds can materialize quickly, rewarding disciplined investors who are well positioned to capture them.
The folly of factor timing
For nearly four decades, Dimensional Fund Advisors has used a systematic approach based on theoretical and empirical research to pursue higher expected returns.
Consistent with valuation theory, research has identified three reliable long-term drivers of the cross-sectional differences in expected stock returns: company size, relative price,¹ and profitability.² Based on this research insight, we build broadly diversified portfolios around these proven factors by systematically emphasizing stocks with higher expected returns (those with smaller market capitalization, lower relative prices, and higher profitability) and deemphasizing stocks with lower expected returns (those with larger market capitalization, higher relative prices, and lower profitability). John Hancock Multifactor ETFs are similarly designed to emphasize stocks with higher expected returns.
We're often asked if it’s possible to time factors successfully. Factors such as size, value, and profitability have delivered outperformance over long time periods, and we expect positive premiums every day, while we recognize that realized premiums can be negative over any given time period. However, there's little evidence to suggest that investors can reliably predict when specific factors will underperform or outperform. In fact, investors may be worse off by moving in and out of factors because the cost of missing the premiums, when they do materialize, can be high. We believe that for long-term investors, building a diversified portfolio with a consistent focus on the long-term drivers of expected return is the best way to capture the premiums associated with those factors.
Markets—and factors—can turn quickly
Lack of discipline in volatile markets may deepen the damage of a market downturn. Ultimately, investors' outcomes are the result of not just market events, but their reactions to those events. Sharp drawdowns in the market are unsettling, but historically, overall U.S. equity returns following sharp downturns have been positive. Lacking a long-term perspective and reacting to short-term negative performance may cause an investor to miss out on the subsequent market recovery, which could lead to suboptimal investment returns.
Much like the overall market, the performance of individual factors can change relatively quickly.
One of the best-known factors, value (relative price), has underperformed over the past decade. It’s disappointing, but not unprecedented. Negative premiums, even 10-year premiums, occur from time to time, and while the odds of realizing a positive premium are never guaranteed, they improve the longer you stay invested.
There have been previous time periods when value stocks lagged growth stocks for several years and then quickly reversed, and the so-called dot-com era provides an extreme, albeit anecdotal, example.
On March 31, 2000, growth stocks had outperformed value stocks in the United States over the prior 1, 5, and 10 years. Many investors at the time began to question their value strategies. However, as of March 31, 2001—1 year and one market swing later— value stocks had regained the advantage over every one of those periods. Investors who had stayed the course, despite negative short-term performance, had the opportunity to capture a positive subsequent value premium.
Multifactor ETFs can help investors navigate this challenging environment
Our expectation is that investing in proven factors will be rewarded over time, and the longer the holding period, the better the odds of outperforming. Of course, there are never any guarantees. However, we believe multifactor investing gives investors a good chance to capture performance premiums if they maintain the proper discipline.
Since there's no way to reliably time equity markets or factors successfully, John Hancock Multifactor ETFs are designed to maintain consistent focus on the long-term drivers of expected returns in all market environments. Targeting multiple factors means investors can benefit from the low probability of all factors being negative at the same time, and consistently targeting each premium means investors will be well positioned to capture the premiums when they're positive.
For investors in multifactor ETFs that pursue the long-term premiums associated with the size, value, and profitability factors, we believe discipline is key. Investors who maintain consistent exposure, even through volatile markets, stand the best chance to reap the potential rewards of a multifactor approach.
1 Relative price as measured by the price-to-book ratio; value stocks are those with lower price-to-book ratios. 2 A company's operating income before depreciation and amortization, minus interest expense, scaled by book equity.