Multifactor ETFs: how are value and small caps performing?
It has been a volatile year in markets, and factors such as size and value have seen swings in performance. That’s why it was important for investors in multifactor ETFs to stay disciplined and committed to a long-term investment approach that pursues higher expected returns and positions investors to capture premiums when they appear.
Seeing the big picture with multifactor ETFs
At Dimensional Fund Advisors, we have a long history of building portfolios to pursue higher expected returns. In equity markets, theoretical and empirical research shows that the long-term drivers, or factors, of equity returns are company size, relative price,¹ and profitability.²
Yet, we know from experience that factors can undergo periods of underperformance, and we don't believe it's possible to consistently predict when factors will outperform or for how long. Throughout 2020, investors faced negative premiums from both the size and value factors, which, while not unprecedented, was certainly disappointing.
Despite the potential for periods of underperformance, we believe maintaining consistent exposure to these three factors is the best way to be positioned to capture the premiums when they do appear. Since the performance of the size, value, and profitability premiums doesn't move in lockstep, using a multifactor approach that combines exposure to all three premiums can improve the reliability of your performance outcomes.
Examining long term performance of the three factors—size, value, and profitability—can help illustrate the importance of consistently pursuing multiple premiums for long-term investors.
Value and small caps stage a comeback
In the wake of last year’s market volatility, I wrote that keeping a long-term focus is extremely important for investors in multifactor ETFs. Individual factors such as size, value, and profitability can materialize quickly, and it is important to stay disciplined in factor exposure to be properly positioned to capture the performance of the premiums when they show up.
Two of the best-known factors—small cap and value—have underperformed their counterparts—large cap and growth—in recent years. However, this underperformance doesn't suggest that the premiums no longer exist. There is compelling theoretical and empirical evidence supporting the size and value premiums, and in the first quarter of 2021, small caps and value stocks had very strong relative returns.
While short-term performance of premiums in the recent past can’t tell us much about future premiums, this recent reversal illustrates why it's important for multifactor investors to stick to their long-term plans.
Factor returns: size and relative price (value), Q1 2021
Q1 2021, U.S. market returns
Source: Dimensional Fund Advisors, as of 3/31/21.
Past performance does not guarantee future results. See below for important disclosures.
Zooming out with factor premiums
Now let’s look at trailing one-year returns as of March 31, 2021, for the three factors. We see that small caps outperformed large caps, while the other two factors (value and profitability) were more mixed.
Factor returns: size, relative price (value), and profitability
One year, as of 3/31/21, U.S. market returns
Source: Dimensional Fund Advisors, as of 3/31/21.
Past performance does not guarantee future results. See below for important disclosures.
To see how the factors have performed over a very long period, we can go back nearly 60 years, the longest available period for which we have data on all three factors. Now we can see the long-term outperformance of all three factors.
Factor returns: size, relative price (value), and profitability
Annualized returns, 1963—Q1 2021, U.S. market returns
Source: Dimensional Fund Advisors, as of 3/31/21.
Past performance does not guarantee future results. See below for important disclosures.
Take a long-term approach with multifactor ETFs
The point of looking at factor performance over multiple timeframes is to remember that premiums aren't guaranteed, especially over shorter periods, but that long-term empirical evidence supports their existence. Individual factors can remain negative for a long time, and then make up the difference (and then some) in a relatively short period of time.
The best way to capture the historical premiums was to remain invested in the factors, which required discipline and a long-term mindset. Multifactor ETFs are designed to be low-cost, tax-efficient tools to allow investors to maintain long-term exposure to these factors in the future.
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.
Important disclosures
U.S. Market Returns are computed from Russell 3000 Index published security weights, Dimensional computed security returns and Dimensional classification of securities based on size, value, and profitability parameters. Within the US, Large Cap is defined as approximately the largest 90% of market capitalization in each country or region; Small Cap is approximately the smallest 10%. Designations between value and growth are based on price to book ratios. Value is defined as the 50% of market cap with the lowest price to book ratios by size category and growth is the highest 50%. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. High profitability is defined as the 50% of market cap with the highest profitability by size category and low profitability is the lowest 50%. REITs and utilities, identified by GICS code, and stocks without size, relative price, or profitability metrics are excluded from this analysis. GICS was developed by and is the exclusive property of MSCI and S&P Dow Jones Indices LLC, a division of S&P Global. Their performance does not reflect the expenses associated with the management of an actual portfolio. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.
John Hancock ETFs are distributed by Foreside Fund Services, LLC in the United States, and are subadvised by Dimensional Fund Advisors LP. Foreside is not affiliated with John Hancock Funds, LLC or Dimensional Fund Advisors LP.
It is not possible to invest directly in an index. Their performance does not reflect the expenses associated with the management of an actual portfolio. Diversification does not guarantee a profit or eliminate the risk of a loss. Past performance does not guarantee future results.
There is no guarantee investment strategies will be successful. Investing involves risks, including the potential loss of principal. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit.
All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
JHAN-2021-0513-1148