What is the Difference Between
Traditional and Non-Traditional Factors?

The four traditional factors defined are momentum, quality, value, and volatility.
More specifically, the traditional factors are high momentum, high quality,
high value, and low volatility. These factors have been studied extensively and
have been shown to produce excess returns vs. the benchmark index over time.

Benchmark indices are created by an index provider, who ranks stocks based on certain criteria, creating a new universe of stocks tracking the factor in question. ETF providers can then create an ETF tracking that factor, which allows investors to gain exposure to the factor of their choice.

A non-traditional factor is simply the opposite side of the four traditional factors. For this article, the non-traditional factors in question are: low momentum, low quality, low value, and high volatility. Just like their traditional factor peers, these stocks are grouped accordingly by S&P factor indexes and tend to exhibit similar performance during certain market environments. The illustration here provides an example of traditional and non-traditional factors:

Why use both traditional and non-traditional factors?

At Pacer ETFs, we believe in using both traditional and non-traditional factors. Traditional factors have been shown to exhibit outperformance vs. the benchmark over a longer time horizon. However, these factors also experience periods of short-term underperformance that can be a drag on portfolio performance. By expanding the factor set to look at both the traditional and non-traditional sides of each factor, investors can enlarge their universe of investable stocks. They can also take advantage of periods of short-term underperformance of the traditional factors.

Additionally, at least one non-traditional factor outperformed the S&P 500 benchmark in 8 of the 10 years between 2011 and 2020. During that same time, a non-traditional factor was the best performing factor in 7 of the 10 years observed. Also, in each of the 10 years from 2011-2020 at least one factor outperformed the benchmark S&P 500, illustrating that factors can be used by investors who wish to generate outperformance vs. the benchmark. The chart here shows how each of the traditional and non-traditional factors performed in each of those calendar years. Note the dispersion of performance of the different factors:

Why rotate between factors?

Now that we know why it makes sense for investors to expand their factor universe, let’s look at how investors may be able to utilize a multi-factor rotation strategy to generate outperformance vs. the benchmark. As we noted previously, there is a large dispersion in the performance of different factors in varying market environments. If an investor were to invest in a single factor strategy, they would be subject to the performance of that strategy during their holding period and could potentially underperform the benchmark.

If an investor chooses to invest in a blended factor strategy, they could potentially dilute their exposure to certain factors and end up with similar performance to the underlying benchmark. For example, suppose someone invests in a fund that has exposure to both low volatility stocks and high quality stocks in a year where low volatility outperforms the benchmark, but high quality underperforms. In that case, the exposure to high quality stocks will act as a drag on their overall performance that year. This is why Pacer ETFs believes in looking at traditional and non-traditional factors and utilizing a multi-factor rotation strategy. Investors can take advantage of the dispersion of factor performance by rotating between factors based on which of those factors are exhibiting the best risk-adjusted performance during that period. Since factors move in and out of favor, a dynamic strategy that broadens the investing universe and utilizes multi-factor rotation may allow investors to take advantage of varying market conditions to maximize investment returns.