ETF strategy for long-term investors: focus on portfolio construction, not factor timing

Small-cap value stocks are near historic valuation and performance extremes versus large-cap growth stocks, so it’s natural that some investors are wondering if now is a good time to step in and buy the laggards. However, rather than bargain-hunting and trying to time individual factors such as size and value, we believe multifactor exchange-traded funds (ETFs) are best used as strategic portfolio-construction tools for long-term investors.

Time for small-cap value stocks?

Factor investing is based on academic research showing that stocks with specific characteristics, known as factors, have historically outperformed the market over longer time periods. Size (small caps) and value are perhaps the best-known factors, but there are others—such as profitability (quality) and momentum.

The truth is that individual factors like size and value can fall out of favour, sometimes for years, despite their historical long-term outperformance. That’s why strategies that combine several factors, such as multifactor ETFs, may help investors stay on track.

Recently, small-cap value stocks have underperformed while large-cap growth stocks have been hot—particularly some of the market’s biggest tech companies. We believe the dominance of large-cap tech stocks can create diversification and concentration issues for core equity portfolios, which we discuss later.

Bar chart. U.S. large cap growth has outperformed U.S. small cap value by a wide margin over one, three and five year periods. The gap narrows at the ten year period.

The performance disparity between U.S. small-cap value and large-cap growth, which has been particularly acute over the past year, has some contrarians asking if now presents an opportunity to buy or add to small-cap value stocks.

However, we think this market-timing approach is the wrong way to think about factor investing and multifactor ETFs for several reasons, including:

We don’t believe it’s possible to predict which factors will perform best. It’s difficult to time individual factors such as momentum, quality, value, and size.

History shows that market trends, such as the outperformance of large-cap tech stocks, can continue longer than many expect—and then reverse very quickly.

Therefore, the admittedly unexciting answer is that we believe the best way to capture factor premiums is simply to remain invested rather than trying to time them. That’s why we recently wrote that discipline is key for investors in multifactor ETFs, particularly in volatile markets or when individual factors are underperforming.

Remember, individual factors like value can recoup years’ worth of underperformance in a very short period during major market shifts, as after the dot-com bust. This is more evidence arguing for simply maintaining exposure to factors as a practical, realistic way to capture the long-term performance premiums.

Portfolio construction and multifactor ETFs

Aside from efficient tools to capture long-term factor premiums, we believe multifactor ETFs may also help solve common portfolio construction challenges in today’s environment.

For example, many investors use the market capitalization-weighted S&P 500 Index for core exposure to U.S. stocks. However, the recent dominance of large-cap tech stocks means the index is getting more top-heavy, which may create hidden concentration risks.

The S&P 500 Index is also seeing its concentration in the tech sector rising to the highest levels since the dot-com bubble.

Line chart. Top five holdings of S and P 500 Index as a percentage of total weight from January 1991 to June 30 2020. 1990 percentage was approximately 11%, approximately 16% in 1999 and at a new high of approximately 20% as of June 30 2020.

The S&P 500 Index is also seeing its concentration in the tech sector rising to the highest levels since the dot-com bubble.

Line chart. Technology sector weighting of S and P 500. Approximately 6% in 1990, peaking approximately 31% in July 2000 prior to tech bubble crash. Current level is nearly 24%.

Multifactor ETFs could be one way to diversify or complement core U.S equity portfolios that may be concentrated in large-cap tech and growth stocks.

A strategic approach

Putting it all together, when it comes to factor investing, we favor a time-in-the-market approach rather than a market-timing approach. We think combining several factors in a multifactor ETF can help keep a long-term perspective, since other factors such as profitability may outperform when things like size and value are lagging. Finally, multifactor ETFs may also be used as portfolio construction tools to address concentration risks due to the recent outperformance of large-cap tech stocks.

It is not possible to invest directly in an index. Past performance does not guarantee future results.

Manulife ETFs are managed by Manulife Investment Management Limited (formerly named Manulife Asset Management Limited). Manulife Investment Management is a trade name of Manulife Investment Management Limited. Commissions, management fees and expenses all may be associated with exchange traded funds (ETFs).

Investment objectives, risks, fees, expenses and other important information are contained in the ETF facts as well as the prospectus, please read before investing. ETFs are not guaranteed, their values change frequently and past performance may not be repeated. Value stocks may decline in price. Diversification does not guarantee a profit or eliminate the risk of a loss. It is not possible to invest directly in an index. Past performance does not guarantee future results.

© 2020 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information.

The information and/or analysis contained in this material have been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness or completeness and does not accept liability for any loss arising from the use hereof or the information and/or analysis contained herein. Manulife Investment Management disclaims any responsibility to update such information. Neither Manulife Investment Management or its affiliates, nor any of their directors, officers or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained herein.

All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management Limited, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment or legal advice. Past performance does not guarantee future results. This material was prepared solely for informational purposes, does not constitute an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.

Manulife, Manulife Investment Management, the Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.

Jonathan d’Auvergne

Jonathan d’Auvergne, 

Director of ETFs

Manulife Investment Management

Read bio