The last decade has been a painful one for investors who believe in a factor-based approach to investing and have stuck with those factors that have historically performed well, namely the value factor, which has severely underperformed growth over those 10 years. But a breed of products have avoided the plight. Funds and ETFs that were designed to be nimble and allocate across a range of factors have not suffered the same performance deficit.
John Lunt is the president and founder of Lunt Capital Management. John has created a series of dynamic and tactical investment strategies used by financial advisors around the country. Lunt Capital has built custom indices, calculated by S&P Dow Jones and by NASDAQ Global Indices that are used as the engines in ETFs, separate accounts and model portfolios.
I spoke with John on February 20.
To listen to this interview as a podcast, click here.
Tell me about the history of Lunt Capital and your vision in creating the firm.
Prior to launching Lunt Capital, I managed funds for our own family office. I'd served as a trustee for the state of Utah's multi-billion dollar pension fund and it was easy to see the advantages of institutional investors. They had better access to asset class diversification and access to a variety of investment strategies.
Lunt Capital has strived to bring those institutional investment advantages to all different types of investors and that naturally pointed us to ETFs and to managed-ETF portfolios. We were very, very early adopters of ETFs, and the evolution of the ETF marketplace has closed that gap and allowed us to deliver portfolios with institutional advantages to all different types of investors
I noticed on your website that your management team recently did an extensive amount of traveling. They circled the globe twice in about a 100 days. You called it the investment trek. What was the idea behind that and what were the key insights that you came away with?
We believe in a global investment perspective and we wanted to understand those risks and opportunities firsthand. So we did exactly that. We circled the globe twice, held meetings with fund managers, economists, government officials, central banks and a wide array of market participants.
But one thing was clear to us through that experience. As U.S. investors, we think of our portfolio in terms of a U.S. bucket and everything else. That international bucket is going to capture everything else in the portfolio. What we knew and reconfirmed is that “everything else” is very, very diverse. Germany is different from India, which is different from China, which is different from Australia and on and on. It provides interesting opportunities within that international bucket when you notice those differences.
A second major takeaway was we could see what we would call a “freedom factor.” The countries with more economic and political freedom would provide a better long-term investment return.
The investment trek to us as is a mindset rather than an event. Last year we were in Shanghai, Mexico City and London. We need that firsthand perspective to global markets.
Let's turn to what you're known for, which is factor investing. Why has there been such a focus in the industry on factor investing?
Factor investing was the outgrowth of the concept that many in the industry had, which was that there was nothing to do except invest in market-cap beta. Many believed that's what you had to do in your equity portfolio in particular. In its most basic sense, factors are grouping together stocks using any of their characteristics other than market cap. There's been a great deal of academic and industry research that's coalesced around the persistence of certain factors like momentum, quality, value and low volatility.
You're known for rotating across factors instead of simply buying and holding them. Why do you do that?
While factors exhibit attractive long-term performance, they definitely have months, quarters or years of underperformance where they go in and out of favor and in and out of season.
In 2016, I wrote an article, Low Volatility is Not a Buy and Hold Strategy. The article pointed out that the low-volatility factor has had impressive outperformance over a 15-year period. But I highlighted that from 2010 to 2013, three out of those four years, the low-vol factor was the poorest performing factor, with dramatic underperformance relative to the benchmark.
To us it made sense to build strategies that rotate, that attempt to adapt as factors go in and out of season. A lot of the buy-and-hold strategies that blend factors together end up looking a lot like the market and the benchmark. Rotation allows a strategy to express an opinion about factors.
Many advisors who will read this will be skeptical of the concepts of factor rotation and tactical allocation because they'll associate them with market timing. What's your response to that concern?
We utilize our rules-based strategy that's not based on prediction, but rather attempts to adapt to factors as they move in and out of favor. It's important to follow this repeatable process. Factor rotation and tactical allocation are something desirable and valuable as you incorporate them into your strategy diversification within your total asset allocation. The opportunity to avoid or reduce exposure to the value factor in recent years has been important. The concept of using a rules-based approach to adapt to market conditions is an important part of an asset allocation.
You mentioned the value factor. What is the universe of factors that you use within your rotation strategies?
We focus on four factors where there's been a lot of research that shows factor persistence over time: momentum, quality, value, and low volatility. Those are robust, powerful factors. But those factors have seasons of underperformance, like value has experienced. It makes sense to us that the opposite side of those traditional factors may perform well during underperformance of a traditional factor.
Our rotation universe includes that traditional side of those four factors, but also the opposite side of the four factors. Our universe ends up being high and low momentum, high and low quality, high and low value and high and low volatility.
You're including some non-traditional factors within that opportunity set. Talk about those and why you use them.
That's noteworthy because the data suggests that you would not want to buy and hold low momentum, low quality, low value or high volatility for a 15-year period. You're likely to underperform. However, you will find months, quarters and years where these non-traditional, opposite-side factors outperform. Just as an example, our strategy often “owns” the low-volatility factor, but there are times you want to “rent” the high-volatility factor.
What are some of the advantages and challenges that are associated with the type of factor rotation strategy that you just described?
These strategies attempt to adapt to factor trends, rather than predict those factor trends. Because of that, one of the challenges is that you're going to be late coming in to a particular factor. You're likely to be late getting out of that factor as it rotates.
But it does a good job of capturing meaningful factor trends. One of the advantages is that factor rotation creates an opinionated factor strategy. It will look different from the benchmark. That's desirable, but certainly when you're underperforming, it is less desirable. That's one of the characteristics that can be viewed as an advantage or a challenge. You are going to look different from the benchmark.
How often do you rotate your strategies?
That timeframe question is important to review. Our model is willing to make changes on a monthly basis, and to us that intermediate timeframe seems like the right time frame. It's not so active that it is changing factors based on noise, but it is sensitive enough to adapt to meaningful trends.
That doesn't mean that there are changes every month. In our multifactor model, where we evaluate the high and the low of those four factors I mentioned, in 40% of the months there is no change in any of the four factors. It doesn't change all the time, but it's sensitive enough when we look at it on a monthly basis to adapt as factor conditions change.
Can you give me a sense of what your allocations are? Which factors you like right now?
As we look at our multifactor rotation strategy, it's currently in the high-momentum factor. It's in the high-quality factor. It's actually in the low-value factor and the low-volatility factor. Those factors can change. They may be different at the end of this month. One of the real benefits of this approach is that in a period when value underperforms, it has the ability to rotate to the opposite side and be in low-value. The opposite of value is not growth. The opposite of value, traditional value, is “expensive”.
Low value has been an area of the market that meaningfully outperformed in a year like last year. It doesn't mean the value factor doesn't work. We think that long term it does and it will rotate back in favor. That ability to adapt as those different factors go in and out of favor is important.
Why did you choose to package this strategy within an ETF? Tell me about the ETFs that your company offers.
The ETF wrapper is ideal for this type of factor-rotation strategy. In a separate account, it would generate lots of transactions with tax consequences. If it were in a mutual fund structure, particularly in a strong up-year with the type of rotation that occurs, you'd likely distribute significant capital gains.
But the unique in-kind redemption creation process of an ETF creates amazing tax efficiency. This is an ideal strategy for the ETF structure.
Lunt Capital builds these strategies. We partnered with NASDAQ on the multifactor rotation strategy. We partnered with S&P on a single-factor, high-beta, low-volatility strategy. We license those indexes to ETF providers who then use those as the engines inside ETFs. For example, First Trust has a large-cap factor rotation ETF that uses our multi-factor rotation strategy based on our index calculated by NASDAQ. It has the ticker FCTR.
We also have a single-factor rotation strategy that we've licensed. In addition to the ETFs, our strategies are the engines behind separate accounts and model portfolios.
If there's one piece of advice that you would give to advisors who are skeptical about quantitative or factor-driven products, what would that be?
I sincerely believe this is the greatest time in history to invest, because we have so many tools at our disposal to build portfolios that can meet objectives of all different types of investors. These quantitative, factor-driven strategies have a role.
I'd encourage advisors to explore ways that these types of products and strategies can bring diversification to their asset allocation or to a total portfolio. Incorporating these factor-type strategies is going to bring something that looks different from the typical market-cap, passive strategy or even an active manager that's inside the portfolio. There's great value in bringing an opinionated, factor-rotation strategy to the portfolio as an additional layer of diversification.
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The last decade has been a painful one for investors who believe in a factor-based approach to investing and have stuck with those factors that have historically performed well, namely the value factor, which has severely underperformed growth over those 10 years. But a breed of products have avoided the plight. Funds and ETFs that were designed to be nimble and allocate across a range of factors have not suffered the same performance deficit.