The Benefits of Transparency

One of the great advantages of full transparency in strategy methodology and daily holding information is the ability to now objectively measure and evaluate strategy characteristics across the wide range of non-cap-weighted ETF options. This surely represents a leap forward in potential investment-decision quality when one considers the relatively lower transparency of traditional active mutual funds. With ETFs, investors no longer need to wade through backward-looking data (prior returns, for example) to make investment decisions. Investors can now look at current characteristics when assessing ETFs and be clinically objective in comparing and selecting strategies.  

Defining Risk Efficiency

At the most fundamental level, the assessment of a strategy’s forward-looking potential should be based on strength and balance across rewarded risks, as well as the existence and magnitude of exposure to unrewarded or negatively compensated risks. In many regards, the exposure to the latter is more important to understand than the former, yet many investors are unaware of the potential negative impact of such exposures. Defining a conceptual and analytical framework to comprehensively evaluate strategies is a key to better investment decisions.

A hallmark of a highly risk-efficient investment includes maximizing exposure to rewarded risk factors and minimizing exposure to unrewarded risks or negatively compensated risks. As a conceptual starting point, let’s consider risk-factor exposure generated by single-factor index approaches. In FIGURE 1, we constructed proxy portfolios representing “pure” factor exposure across the five primary categories of risk premia. These five “super factors” are supported by substantial empirical, academic research, and their historical return persistence can be explained by risk and/or behavioral rationale.

Finally, investors should consider the forward-looking risk characteristics of any strategy under consideration. The daily transparency of holdings in ETFs allows for a variety of forward-looking risk analytics to be run, including expected volatility, expected tail loss, and downside capture across various stress and market scenarios. In looking across the many strategies on the market, it’s clear there’s wide variation in forward-looking risk, with—as an example in contrast—single-factor low-volatility strategies generating lower-than-market forward-looking risk characteristics and fundamentally weighted strategies generally having higher-than-market forward-looking risk. This isn’t to say that lower- or higher-than-market risk attributes are inherently positive or negative, but to acknowledge that a strategy on either side of the dividing line will likely outperform or underperform depending on the risk environment.

Investors with the clairvoyance required to time factors, sectors, countries, and market risk can certainly use such strategies as tactical tools. For investors looking for factor-based outcome enhancement as a longer-term or core equity holding, identifying strategies with high risk efficiency and less regime dependence is the order of the day.