An extensive discussion on this article is available on APViewpoint in this conversation.
The popularity of smart-beta products has raised concerns that certain factors have been “overgrazed” – that their expected return has been driven down due to popularity-driven demand. A new research paper purports to refute this concern. But its logic is flawed and practitioners should be highly skeptical of its conclusions.
The paper in question is Are Exchange-Traded Funds Harvesting Factor Premiums?. It was written by David Blitz, who is with Robeco Asset Management, a Netherlands-based asset manager and producer of quantitative, factor-based investment products.
Blitz’ paper was published on the SSRN platform and has not appeared in a peer-reviewed publication.
I shared this article with Blitz for his feedback and comments. I also had an email exchange with him to be sure I understood his research correctly.
I have no reason to believe that Blitz is intentionally misleading the investing public. I hope that he believes he is acting in the best interest of Robeco’s clients. I do not have any reason to believe that Robeco’s products are inferior to similar products from other fund companies.
Blitz attempts to refute the “overgrazing” hypothesis by showing that the aggregate exposure to factors among ETFs is close to zero. For example, he shows that the amount of assets invested in ETFs that offer a positive value exposure is roughly equal to the amount invested in ETFs with a negative value exposure.
He concludes that, “On aggregate, all factor exposures turn out to be close to zero, and plain market exposure is all that remains. This finding argues against the notion that factor premiums are rapidly being arbitraged away by ETF investors, and also against the related concern that factor strategies are becoming ‘overcrowded trades.’”
But, as I will explain, his methodology is insufficient to prove his hypothesis. There can be significant overgrazing even though there is net-zero factor exposure.
Before I offer my proof, consider this very rough, imperfect analogy. Let's say that there are a bunch of cars on the highway and that, through an omnipotent police force, an average (median) speed of 55 mph is always enforced. Then someone comes along and observes that there are as many cars traveling over 55 as there are under 55, and concludes that none of the cars going over 55 are accelerating. That is an obviously fallacious and unjustified conclusion. But it is the rough equivalent of Blitz’ findings.
To refute Blitz’ paper, one needs to show that expected returns from factor-based strategies can be driven down even when there is a net-zero factor exposure in the ETF market. Let’s assume that investors have driven up the prices of value ETFs. At the same time, other investors have increased their investment in growth ETFs proportionately to the increase in price of value ETFs[1]. In this case, the net exposure to the value factor among ETFs could be zero, but the expected returns of value ETFs has declined.
Another way to refute Blitz’ analysis is to consider the total market of U.S. equities. By definition, this market has a net-zero exposure to all factors. But we know that segments of the market can be over overvalued (i.e., overgrazed) at points in time, as was the case with growth stocks during the dot-com era. Since a net-zero exposure does not imply that certain strategies cannot be overgrazed in the total market, then, by logical extension, the same must be true of the ETF market, which is a subset of the total market.[2]
Blitz has shown that the landscape of factor exposure in the ETF market resembles that of the entire market, in that both have net-zero factor exposure, which is a notable finding. I actually would have expected the value premium to be under-represented in the ETF market, because of Dimensional Fund Advisors (DFA). DFA has hundreds of billions of dollars exposed to the value premium and, until very recently, that was entirely in mutual funds. But Blitz has shown that despite DFA’s near-absence from the ETF market, ETFs still have a net-zero exposure to the value premium (and to other premia).
The strongest conclusion that Blitz makes in his paper, and which he confirmed with me via email, is that one cannot claim that the amount of dollars invested in factor-based ETFs is evidence of overgrazing. There may be overgrazing, but it will take more than just a knowledge of the dollars invested to determine that.
It may be possible to detect situations where the expected returns of ETFs have been driven down, for example by looking at valuation “spreads” (e.g. the difference between price-to-book multiples on value and growth ETFs). But that is not what Blitz has done.
In an age where many are increasingly challenged to distinguish fact from fiction in all realms of discourse, it is imperative that we apply the utmost scrutiny to financial research. Placing our clients’ best interests ahead of our own means approaching all research with a healthy level of skepticism.
Fiduciaries should not rely on Blitz’ research.
[1] The fact that the prices of value ETFs went up would result in changes to their factors. But the amount of money invested in growth ETFs could increase or decrease by a sufficient amount to maintain the net-zero factor exposure in the ETF market, since shares of ETFs are created and destroyed dynamically based the flow of assets to and from ETFs.
[2] If it is not clear that this is true by logical extension, then here is a further proof. Assume the opposite – given that a net-zero exposure does not imply that certain strategies cannot be overgrazed in the total market, then, the same is not true of the ETF market. But if that were true, then it would mean that, in the ETF market, a net-zero exposure implies that certain strategies can be overgrazed. But if that is true of the ETF market, it must also be true of the non-ETF market. Since the ETF and non-ETF market comprise the total market, the original statement (Since a net-zero exposure does not imply that certain strategies cannot be overgrazed in the total market, then, by logical extension, the same must be true of the ETF market, which is a subset of the total market) must be true.
Read more articles by Robert Huebscher
