Is OMFL's Approach Really A Game Changer? Conviction Without Certainty

seekingalpha04-20

OMFL implements one of four portfolio regimes based on a model's assessment of the business cycle. Factors emphasized may include size, value, momentum, volatility, and quality.OMFL was the top-...

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Factors emphasized may include size, value, momentum, volatility, and quality.OMFL was the top-...</p>\n\n<a href=\"https://seekingalpha.com/article/4684879-is-omfls-approach-really-game-changer-conviction-without-certainty\">Source Link</a>\n\n</div>\n","source":"seekingalpha","html":"<!DOCTYPE html>\n<html>\n<head>\n<meta http-equiv=\"Content-Type\" content=\"text/html; charset=utf-8\" />\n<meta name=\"viewport\" content=\"width=device-width,initial-scale=1.0,minimum-scale=1.0,maximum-scale=1.0,user-scalable=no\"/>\n<meta name=\"format-detection\" content=\"telephone=no,email=no,address=no\" />\n<title>Is OMFL's Approach Really A Game Changer? 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Conviction Without Certainty\n</h2>\n\n<h4 class=\"meta\">\n\n\n2024-04-20 20:07 GMT+8&nbsp;&nbsp;&nbsp;<a href=https://seekingalpha.com/article/4684879-is-omfls-approach-really-game-changer-conviction-without-certainty><strong>seekingalpha</strong></a>\n\n\n</h4>\n\n</header>\n<article>\n<div>\n<p>OMFL implements one of four portfolio regimes based on a model's assessment of the business cycle. Factors emphasized may include size, value, momentum, volatility, and quality.OMFL was the top-...</p>\n\n<a href=\"https://seekingalpha.com/article/4684879-is-omfls-approach-really-game-changer-conviction-without-certainty\">Source Link</a>\n\n</div>\n\n\n</article>\n</div>\n</body>\n</html>\n","isBrief":false,"type":0,"news_type":1,"symbol":"BK4533","symbol_name":"AQR资本管理(全球第二大对冲基金)","start_time":0,"source_url":"https://seekingalpha.com/article/4684879-is-omfls-approach-really-game-changer-conviction-without-certainty","article_id":"2428625912","we_media_id":null,"thumbnails":["https://static.seekingalpha.com/cdn/s3/uploads/getty_images/1223839126/image_1223839126.jpg"],"rights":null,"url":"https://stock-news.laohu8.com/highlight/detail?id=2428625912","pubTimestamp":1713614862,"sourceInfo":{"source_id":"seekingalpha","name":"Seeking Alpha"},"weMediaInfo":null,"summary":"OMFL implements one of four portfolio regimes based on a model's assessment of the business cycle. 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Factors emphasized may include size, value, momentum, volatility, and quality.OMFL was the top-performing all/large-cap blend ETF for the five years ending December 2022. However, its ranking since is only #67/117, providing more evidence that past performance is unreliable.However, it's also unfair to use past performance to justify selling. A more reasonable approach is to assess OMFL's fundamentals and decide if you believe the risk exceeds the reward.My fundamental analysis reveals OMFL has implemented a \"recovery phase\" portfolio, which involves holding highly-volatile small- and large-cap stocks with little momentum.The current portfolio is risky, and OMFL might be better suited for traders looking to capitalize on short-term opportunities rather than for long-term buy and hold investors.   everydayplus/iStock via Getty Images Investment Thesis It's been one year since I initiated coverage on the Invesco Russell 1000 Multifactor ETF (BATS:OMFL). In that article, I expressed my skepticism over the sensitivity of its proprietary model and reminded readers not to rely on past performance when deciding which ETF to buy. Indeed, OMFL has lagged behind benchmarks like the iShares Russell 1000 ETF (IWB), the Vanguard Dividend Appreciation ETF (VIG), and the Invesco S&P MidCap 400 Pure Value ETF (RFV) over the last year. Today, I will compare OMFL with two other multi-factor funds with different combinations of size, volatility, growth, valuation, and quality. In addition, I'll provide a comprehensive factor analysis by sector and sub-industry that indicates the model implemented a \"recovery phase\" regime earlier this year, express my concerns with this selection, and explain how the evidence does not support buying ETFs based on past performance. As a fair warning, this article is lengthy, but I hope to keep you engaged, and I look forward to answering any questions you might have in the comments section afterward. OMFL Overview Strategy Discussion OMFL tracks the Russell 1000 Invesco Dynamic Multifactor Index. The Index is proprietary and selects U.S. stocks based on a proprietary model's assessment of the current economic cycle. Indicators include:  manufacturing business surveys monetary conditions housing activity equity and fixed-income returns  Depending on the results, the model emphasizes certain factors, as follows: Invesco In previous reviews, I've determined the model has assessed we've spent most of the past couple of years in either the \"expansion\" or \"slowdown\" phase, which emphasizes different factors. The expansion phase emphasizes size, value, and momentum and is somewhat similar to a \"pure value\" approach with highly volatile small and mid-caps. Meanwhile, the slowdown phase is more what you'll find with defensive large-caps. The model appears free to move back and forth between phases rather than move through them in a single direction, a feature that strikes me as odd. Consider how the National Bureau of Economic Research \"waits until sufficient data are available to avoid the need for major revisions to the business cycle chronology.\" In contrast, OMFL moves quickly between business cycles, which doesn't reflect reality. According to its annual report, OMFL's portfolio turnover rates from 2020 to 2023 were 321%, 126%, 336%, and 350%, respectively. To explain this high portfolio turnover, I offer two possible explanations:  The model makes frequent incorrect assessments of the business cycle. The model is extremely sensitive.  The first option is a stretch, as I trust the managers are skilled and relied on several decades' worth of information to develop the model. Instead, the second choice is most likely. To illustrate what I mean by \"sensitive,\" consider this hypothetical exchange between an investor and their advisor, discussing potential changes to the investor's portfolio.  Advisor: I've been following market condition changes lately and have decided that your equity portfolio needs a complete overhaul. Investor: A complete overhaul? What changed? Advisor: Recent data indicate the economy is not in the slowdown phase, which is what is optimal for your defensive blue chip portfolio. Instead, the economy is expanding, and historically, more volatile small- and mid-cap stocks outperform. Investor: That makes sense, but I'm surprised at how sudden this feels. I'm not ready to take on extra risk without knowing more. How confident are you that we are in the expansion phase, not the slowdown phase? Advisor: I rely on a quantitative model to assess the probabilities of each phase. Currently, the model indicates a 51% chance we are in the expansion phase and a 49% chance we are in the slowdown phase. These probabilities were reversed last week, hence the reason for today's call. Investor: It doesn't sound like the model is sure one way or another. Please hold off on any changes, but can you check back when the probability is closer to 60%? I just don't want to be making changes to my portfolio unless it's based on something concrete. Advisor: Absolutely. I monitor the probabilities daily and will set a reminder to call you when conditions change more. You can also give me a call anytime for the latest numbers.  In this situation, the investor was right to question the reasons for overhauling their entire portfolio. By asking a simple question about conviction, the investor learned that the relied-upon model is unsure which portfolio regime is optimal. Unfortunately, OMFL investors don't have that luxury, as the model is a virtual \"black box,\" and we don't know the conviction behind drastic changes that can occur as frequently as monthly. This criticism is not a knock on rules-based funds, as removing humans from the decision-making process is potentially advantageous. However, the difference is most rules-based funds have buffer rules set up to prevent unnecessary turnover and usually only reconstitute one or two times per year. Many ETFs also consistently emphasize factors such as volatility and quality, making it easy for investors to use them as building blocks for a broader investment strategy. Instead, OMFL seems better suited for active traders looking to capitalize on short-term opportunities. Performance Analysis OMFL has gained 118.97% since December 2017, compared to 106.46% and 110.28% for IWB and the SPDR S&P 500 ETF (SPY), respectively. These results are excellent, especially OMFL's downside risk-adjusted returns, as measured by its 1.03 Sortino Ratio. Portfolio Visualizer This Sortino Ratio result reflects how OMFL matched or exceeded IWB and SPY's returns when stock prices rose and then outperformed by 4-5% in 2022. On December 31, 2022, OMFL's five-year annualized returns were an outstanding 12.13% compared to 8.98% and 9.33% for IWB and SPY. To investors relying on these results, buying into OMFL was a no-brainer. Portfolio Visualizer However, my analysis involving hundreds of U.S. Equity ETFs across all size segments and styles proved that five-year trailing returns were not good indicators of five-year forward returns. Specifically, ETFs ranking in the top two quartiles delivered slightly below-average returns (52nd percentile) over the next five years. In OMFL's case, its 12.13% annualized return from 2018 to 2022 ranked #1/117 in the all/large-cap blend category, but its total returns since January 2023 ranked just #67/117. In short, evaluating an ETF's past results has little value, and if this is your primary method for determining what to buy next, I suggest you reconsider. OMFL Analysis Determining The Current Business Cycle Phase Fortunately, ignoring past performance does not mean investors are helpless. Alternative approaches include evaluating the reasonability of the fund's strategy and examining the fundamentals of the ETF's current portfolio. I discussed the strategy above and listed some perceived flaws, namely its highly sensitive model and a lack of transparency in the proprietary approach. Next, let's evaluate OMFL's current sector exposures and certain volatility and quality features to gauge risk. The Sunday Investor Here are three observations to consider: 1. OMFL's weighted average market capitalization is $11.75 billion compared to $728.16 billion for IWB. Undoubtedly, the \"size\" factor is emphasized, meaning the model has determined we are either in the recovery or expansion phase of the business cycle. In addition, the volatility factor (as measured by beta) is not emphasized, which is characteristic of only the slowdown and contraction phases. 2. The quality factor is also not emphasized. The table above reveals net and free cash flow margins 7-10% less than IWB, a high weighted average debt-equity ratio, and a low 7.08/10 overall profit score. However, its asset turnover ratio is solid, primarily due to its 15% exposure to Consumer Discretionary. 3. The model emphasizes the momentum factor in the expansion phase but not the recovery phase. To decide if this applies, here are some momentum statistics by sector comparing OMFL with IWB. The Sunday Investor Based on these weighted-average results, it's difficult to argue that the model emphasizes the momentum factor. Current prices relative to 50-200 day moving average prices are similar to or slightly worse than IWB, and the discrepancy is larger with mid- and long-term 1-10Y returns. Therefore, I'm confident the model has determined that we are in the recovery phase. Now, does this make sense? It's a challenging question, as there are varying opinions. For example, analysts at Fidelity write, in part: Many major economies, including the U.S., remained in the late-cycle expansion phase and registered hints of stabilization and even reacceleration in some areas. Expectations of monetary easing have contributed to improving global financial conditions, and worldwide manufacturing activity has firmed. Fidelity The graph above indicates economically sensitive assets perform best in the recovery and contraction phases, which support OMFL's relatively high allocation to Consumer Discretionary stocks. However, if the analysis above is correct and the contraction phase is next, OMFL must revamp its portfolio once more to avoid underperformance. Not doing so is the critical risk today, and referring back to the earlier hypothetical discussion, I wish I could make a phone call to find out how confident the model is one way or another. OMFL Fundamentals By Sub-Industry The sector analysis above is a great way to quickly assess an ETF without relying on past performance. You can get a feel for which factors are emphasized and how the selections were made. For example, the Consumer Discretionary and Financials stocks have delivered minimal returns over the last three years, so they may be good value picks. OMFL's 1.30 five-year beta is driven mainly by Consumer Discretionary and Energy, and except for Energy and Financials, free cash flow margins are low. This information is valuable for any ETF investor, but unfortunately, it's not readily available, so investors turn to past performance by default. For a deeper look, we can evaluate an ETF at the sub-industry level, which is a nice compromise, as OMFL currently has 374 equity holdings and only 8.68% allocated to its top ten. As I did above, I'll benchmark against IWB, but I've also included the same metrics for the BlackRock U.S. Equity Factor Rotation ETF (DYNF) and the Global X Adaptive U.S. Factor ETF (AUSF), two ETFs suggested to me by readers of my last review of OMFL. I encourage these suggestions, so I hope you'll take the time to make some more in the comments section in a few minutes. The Sunday Investor Here are three additional observations: 1. OMFL currently takes a \"deep value\" approach, evidenced by its 14.77x forward earnings valuation (simple weighted average method) and relatively high 4.72/10 value score. These selections are usually quite volatile, but volatility is further enhanced because OMFL primarily holds small- and mid-cap stocks. To reiterate, OMFL will need to change gears before a broad stock market decline to protect prior gains. Pure value ETFs like RPV and RFV often underperform in major drawdowns due to their high betas and low quality. Portfolio Visualizer A significant drawdown is always possible, as analysts at Russell Investments write how \"the risks of a sharper economic slowdown later in 2024 are elevated\". However, since OMFL does not reconstitute on a fixed schedule, the hope is that it can pare losses by switching to the defensive \"slowdown\" portfolio. Unfortunately, this is only an educated guess on my part, as I don't have insight into the model's mechanics. 2. DYNF is a less volatile alternative with a weighted average market cap nearing $1 trillion. In addition, it trades at 27.53x forward earnings and has an excellent 9.87/10 profit score, so it couldn't be more different than OMFL. Its Fact Sheet notes how it evaluates stocks based on the same five factors as OMFL, so I expect these two ETFs to deliver remarkably different returns in the near term but possibly converge over the long run. Portfolio Visualizer 3. AUSF is an interesting alternative to OMFL because its $91.82 billion weighted average market capitalization figure indicates it also has exposure to small- and mid-cap stocks. While it still includes mega-caps like Berkshire Hathaway (BRK.B), PNM Resources (PNM), valued at $3.24 billion, is AUSF's #10 holding. Global X If you are concerned about OMFL's volatility, AUSF solves that problem, as its weighted average five-year beta is just 0.93. AUSF also features better growth and quality while trading at an attractive 16.44x forward earnings. Like DYNF, AUSF is cutting into OMFL's lead with its less risky, high-quality approach. Portfolio Visualizer Investment Recommendation OMFL relies on a proprietary model to assess the current phase of the business cycle and then implements a specific portfolio type to optimize returns. While this model was developed based on decades worth of information, it is flawed because it is so sensitive. It wouldn't be prudent for an investment advisor to overhaul an investor's portfolio several times yearly, so I wonder why one would afford that latitude to an algorithm. Still, there are obvious benefits to being flexible if market conditions drastically change, so it's most fair to take a neutral position on the model.  I want to reiterate how an ETF's historical returns are not good indicators of forward returns. I believe relying on past performance is done out of convenience, as detailed portfolio metrics by sector and sub-industry are not easy to find. However, calculating them is worthwhile because investors can learn the factors that drove past performance and adjust as needed. In OMFL's case, my analysis highlighted the portfolio's high 1.30 five-year beta and low quality, two features that aren't apparent in the performance chart but are known to underperform in bear markets. Therefore, I urge readers to proceed cautiously with OMFL, and I have decided to reiterate my \"hold\" rating on the ETF. Thank you for reading, and I look forward to your comments below.","kind":"highlight","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.3","shortVersion":"4.29.3","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2428625912"}