‘Buyer beware' is the main message from analytical software provider Axioma to investors in the increasingly popular field of factor-based ETFs.
Investors have embraced passive products that concentrate their exposure on specific factors, with low volatility in stocks proving particularly popular with risk-budgeting allocators.
But research by Axioma suggests the way some such ETFs are constructed may risk clients being inadequately diversified, and taking unintended factor bets - affecting both risk and returns in the process.
"Two of the classic rules of thumb for investors are to avoid unintended bets and diversify," says Anthony Renshaw (pictured), author of Axioma's study. "Because of their simple construction methodology, simple factor ETFs are fertile ground for both unintended bets, and poorly diversified holdings."
Axioma runs analysis on the PowerShares S&P 500 Low Volatility Portfolio. It beat the broader, volatile, US market that fell modestly last year.
The 100 stocks in the ETF are those in the S&P 500 index with lowest realized volatility over the past 12 months, weighted in inverse proportion to their ranked volatility, says Axioma. The stocks are rebalanced quarterly.
Axioma notes such a simple procedure may explain the popularity - but it also points to potential problems.
In early March, for example, the methodology exposed clients 59.4% to just two sectors - utilities (29.9%) and consumer staples (29.5%) - Axioma says.
"While one would expect these two sectors to be large in a low volatility product, allocating almost 60% of the fund to only two sectors may strike many portfolio managers as insufficiently diversified," Anthony Renshaw says.
"If an event such as the Japanese earthquake and tsunami occurred with a particularly negative impact on Utilities, SPLV performance would suffer accordingly, but even a less dramatic event could have a significant impact."
Axioma also says the ETF could unintentionally be taking bets on other style risk factors besides low volatility, in a way that is much more magnified than in the S&P 500 index overall.
The research showed the ETF's ‘active style exposure' was more than one standard deviation negative than the exposure in the S&P 500 overall, "indicating a strong small-cap bias.
"Liquidity is also biased negatively, indicating that the holdings of [ETF] are less liquid than the S&P 500. On the other hand, [the ETF] has a strong positive exposure to exchange rate sensitivity, indicating that, relative to the S&P 500, [the ETF] has more exposure to companies that prefer a strong US dollar."
Axioma's study also pointed to the ETF's notable tilt recently away from benchmark exposure in regards to medium-term momentum stocks, which did very well over the last year.
Axioma's paper acknowledges it produces what it calls a ‘purified' version of the tracking product, with 100 stocks, aiming in part to limit active exposure to eight other ‘non-target factors' to within one quarter of one standard deviation from the index, "to reduce unintended consequences.
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