Traditional factor-based strategies are vulnerable to more downside than investors think – that’s according to Ted Theodore, CFA, Portfolio Manager of the TrimTabs Float Shrink ETF (TTAC ).
Theodore argues that Smart Beta ETFs have lulled investors into a false sense of security because they fall short of protecting against “financial engineering” risk.
ETF Trends spoke with Theodore about his theory that factor-based strategies may be vulnerable if there is a serious sell-off.
ETF Trends: Can you elaborate on the dangers of “financial engineering” risk and why Smart Beta ETFs can’t help to protect investors from it?
Theodore: These are two separate issues. Financial engineering today arguably is most related to the practice of companies who like the impact of a reduced share count on their earnings per share, sales per share and on.
However, when those share reductions happen because the company has borrowed money to pay for the repurchases, then the company is “engineering” only a cosmetic change, and one which carries the increased possibilities of danger if the condition of its balance sheet deteriorates materially. Except for ETFs that specifically target buybacks, Smart Beta ETFs are only indirectly affected by this kind of financial engineering.
However, since the clear majority of buybacks are financed with debt and it is a widespread practice, any adverse change in the interest rate or economic environment can introduce a risk to any ETF that was not contemplated.
ETF Trends: Can you explain why traditional factor-based strategies are vulnerable to more downside than investors think?
Theodore: The effectiveness of factors has been postulated by academic research but only when given enough time for the factor to influence results.
In practice, most factor research suggests this time frame must be measured in years – typically five years or more. What this means practically is that there can be periods of time, lasting 1-2 years, when the factor is out of favor and not delivering on its longer-term promise.
Indeed, most of the popular factors are volatile. So, for example, the “value” factor has been a very big disappointment over the last 18 months or so. Should a period of relatively disappointing short run performance occur in a sideways to down market, the negative impact is clearly magnified. It seems unlikely investors are aware enough about the volatility of factors.
ETF Trends: What are the advantages of combining free cash flow with stock buybacks?
Theodore: As indicated above, buybacks financed with debt can create long term challenges to companies. On the other hand, if a company has strong enough free cash flow, it can finance share reduction by utilizing a portion of that free cash flow instead.
An additional consequence is that the latter kind of company is typically growing more rapidly and improving its finances at the same time. That is a formidable combination in a market where many are cautious about the economy and interest rates.
For more news, information, and strategy, visit the Free Cash Flow Channel.
