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How to Minimize Luck in Indexing

It's important to understand how your fund's benchmark rebalances.

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Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. IShares MSCI USA Momentum Factor ETF's untimely rebalancing into value stocks has hurt performance lately. Here to unpack what happened and to discuss luck in indexing more broadly is Ben Johnson. Ben is Morningstar's director of global ETF research.

Hi, Ben, thank you for joining me today.

Ben Johnson: Thanks for having me, Susan.

Dziubinski: Let's start out by talking a little bit about this fund's strategy, in particular, it does practice a momentum strategy. How does it execute that?

Johnson: Well, Susan, this fun--no different than any other momentum strategy--looks to harness the momentum factor. What the momentum factor is is really just the tendency for stocks that have performed either particularly well or particularly poorly to continue to do so over the near term. So, it's out there scanning the markets for stocks that have shown strong momentum over the course of the past half-year and the past year, bring those stocks into the portfolio, and then do a line change twice a year to make sure that it's continuing to refresh the portfolio to own the stocks that are showing the highest degree of momentum.

Dziubinski: Then what happened with the fund's recent rebalance? And what influence did that have on returns?

Johnson: Well, what we saw in the case of MTUM's May rebalance was that in the period leading up to that rebalance, value stocks were having a very strong run. So, coming out of the favorable news that we got last year around vaccines and reopening, many of the old-economy stocks, the reopening stocks, whatever you want to label them, really went on a tear, and value stocks writ large looked like they were making a comeback after years of languishing. Now, what happened is that by virtue of bouncing off the bottom, these stocks were demonstrating momentum, greater momentum than the market at large. So, when MTUM rebalanced in May, it rebalanced in a big way into some of these value stocks at precisely the moment that their rebound was about to fizzle out. Take, for example, coming into this rebalance, MTUM had over a fifth of its portfolio invested in the FAANGM names. So Facebook, Apple, Amazon, Netflix, Google, and Microsoft. Coming out of the May rebalance, Google was the last one of the FAANGM left standing. So, it went from a fifth, more than a fifth, of its portfolio in those names to just 5%, having switched in favor of traditional value names, traditional value sectors, at precisely the wrong moment. And what we've seen since is that its performance has suffered relative to its Morningstar Category index, the Russell 1000 Growth.

Dziubinski: Have we seen other instances in the past, of these types of momentum misfires, either specifically with these funds, or have we seen rebalancing misfires like this with other types of funds?

Johnson: I think it's important to note that this is really just one example among many within the realm of index funds where we've seen evidence of rebalance timing luck, and that can be either good or bad luck. This is a topic that we've looked at for some time. Corey Hoffstein at Newfound Research has actually published some really tremendous research that looks at exactly when these different indexes--so be they momentum indexes or value indexes, these aren't necessarily your broad-based market-capitalization-weighted indexes, but indexes that, for all intents and purposes, are a form of active management and active strategy--refresh their portfolios. When do they rebalance? Most notable is what I would refer to as the "immaculate rebalance" in the case of the Invesco FTSE RAFI US 1000 ETF, PRF is the ticker for that fund. So, that fund rebalanced in March 2009, coming off of the very bottom of one of the worst markets in recent memory, and bought the deepest value names precisely when they were priced to effectively go bankrupt, in some cases, and ex-post that timing turned out to be very fortunate that that was very good luck. The MTUM example is just one example among many of bad luck. And I think what many investors need to understand is that even in indexing, especially when indexes for all intents and purposes are active strategies, there's a real role being played by luck. No different than with discretionary active management.

Dziubinski: Then what's the takeaway for investors? If you want to minimize the role of luck in your index portfolio, what do you do?

Johnson: I think first and foremost, you need to understand that no two indexes are created equal, and that when you move away from funds that track broad-based market-capitalization-weighted indexes that might turn over 3% to 5% a year, the role of luck is going to grow over time, and grow, I think, in large part depending on the amount of rebalancing of the type of strategy in question. A fund like MTUM has never had less than 100% turnover in any given calendar year. So, luck is going to play an important role, especially because it turns over just twice in a given year. Investors that are looking at what we call strategic-beta funds, smart-beta funds, factor funds, that have high levels of turnover, luck could very well play a greater role in those portfolios' performance, certainly greater than it would in a broad-based market-cap-weighted index fund.

So, know that full well, and understand what do those indexes do to try to diminish the role of luck, diminish the role of either favorable or unfavorable timing when it comes to rebalancing. That could be rebalancing more frequently, that could be rebalancing the portfolio a piece at a time. There are some index funds that rebalance a quarter of their portfolio at any given quarter during a normal calendar year because they're cognizant of this issue, the potential role of luck, and they want to diminish luck's role and the outcomes that they're delivering for investors. As with any index strategy, as we do in our own due diligence, it's really important to understand these funds' processes as defined by their index methodologies, which are ultimately the DNA of the portfolio. And what specific features of those methodologies of these processes are in there to try to minimize the role of luck in the outcomes for the end investor.

Dziubinski: Well, Ben, thank you so much for your perspective today on luck and index investing. We appreciate it.

Johnson: Thanks for having me, Susan.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thank you for tuning in.

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Ben Johnson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.