Australian ETF News
The Deep Dive – How Flows Effect ETF Factor Performance
There is a host of factor related ETFs, and for good reason. Many investors think asset class, geographic, sector, market cap exposures or thematic exposures. Less so understanding market performance on a factor basis. For example, during the downturn between mid-February and the early part of April this year, outperformance was primarily driven by factors. And in particular, factors like lower beta, lower volatility, strength of balance sheet, stable profit margins, stable if not growing dividend yields outperformed. That is, a quality wrapper, but with that emphasis on the lower beta, lower volatility, those factors that tend not to do well when the market is ripping back on the upside. Many investors know that the performance of factors like value or momentum declines if more investors put money at work in these factors. This is one of the key reasons why factor performance waxes and wanes over time. But thanks to a brilliant study by Nikolay Doskov, Thorsten Hens, and Klaus Reiner Schenk-Hoppé we can put some numbers to this effect. The paper is an absolute must read for every fund manager. They looked at all the stocks traded on the 14 largest stock exchanges in the world and formed portfolios based on the different factors as well as passive portfolios that just replicate the market. They considered both long-short and long only factor portfolios, but I will only deal with long only portfolios here.
Then, in each month from 1995 to the end of 2020, they track the performance of each stock and check which stocks move in and out of the different factor portfolios. This way, they can simulate how investor flows change different factor portfolios over time and how in the medium- to long-term these flows change the returns of different factors. Here is what they estimate happens to the returns of the four main factors – value, small cap or size, momentum, and quality – if 1% of the total market is shifted into these factor portfolios. Note that the total market cap of the stocks in their study is about $60 trillion, so 1% corresponds to net inflows from passive strategies to these factors of c.$600bn worldwide.
As evident in Figure 1, the returns of the value factor are reduced by only 2% p.a while momentum returns decline by about 8.6%. If investors chase the best performers of the past, they quickly reduce the returns of momentum strategies because they push the prices of expensive stocks even higher. Meanwhile, if investors move into cheap value stocks, they reduce the potential future return by much less because these stocks remain cheap – and thus poised for future outperformance – even after the inflows.
Intuitively, one could interpret this as value and small cap portfolios having higher capacity – meaning they can digest more inflows before their outperformance disappears. But this is not true because different factors have different long-term performance. If we turn the calculation around and ask what percentage of the total market needs to move into the factor portfolios before the outperformance disappears, we get the chart in Figure 2.
Because the average outperformance of value strategies vs, the market is much smaller than the average outperformance of momentum portfolios. In the end, value and small cap strategies have the least capacity and their outperformance tends to disappear if a mere 0.17% of the total market cap (c.$102bn) and 0.07% of market cap (c.$42bn) flow into these factors globally.
What is particularly interesting, though, is that the study also estimates cross-factor impacts.If more money flows into momentum stocks, the expensive stocks tend to get more expensive while the cheap stocks tend to get cheaper.This should increase the return potential for value investors.