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....