Factor Optimization via ETFs
Is a value ETF necessary to gain exposure to the value factor?
June 2024. Reading Time: 10 Minutes. Author: Nicolas Rabener.
SUMMARY
- Factor exposures can be acquired from various sources
- For example, energy stocks are cheaper than stocks from a value ETF
- However, these may come with additional factor exposures
INTRODUCTION
In our recent article, “The Pitfalls of Portfolio Optimization,” we demonstrated that optimizing portfolios for Sharpe ratios or target volatility often leads to disappointing out-of-sample performance. In every case, realized Sharpe ratios were lower than in-sample, and actual volatility consistently missed its target.
Another common approach is tilting portfolios toward specific factors like value or quality, either through individual stocks or ETFs. However, given the underwhelming results of traditional optimization, it’s worth questioning whether factor tilting offers a more reliable path to success.
In this research article, we investigate the effectiveness of factor optimization using ETFs.
FACTOR OPTIMIZATION
We analyze a universe of well-known asset class, sector, and factor ETFs to gain exposure to the value factor. Our approach involves optimizing for beta to the value factor by selecting one or more ETFs over rolling 5-year in-sample periods, beginning in 2004. When we allow the optimization to freely select ETFs with the highest value exposure – what we refer to as unconstrained optimization – the result is a 100% allocation to energy stocks via the Vanguard Energy Index ETF (VDE).
Given this somewhat counterintuitive outcome, we introduce a constraint by limiting the universe to asset class and factor-focused smart beta ETFs. Under this constrained optimization, the model allocated 100% to the iShares Russell 1000 Value ETF (IWD) during the in-sample period from 2004 to 2009.
