Morningstar Magazine - October/November 2016 - 57

EXHIBIT 2 What E X H I B I T 1 doesn't adequately depict is the cyclicality of these factors' performance. While each of the factor variants of the MSCI World Index delivered better absolute- and in most cases risk-adjusted-performance relative to their parent benchmark during the period in question, it was not smooth sailing. This is apparent in E X H I B I T 2 , which is the "periodic table" of these factor indexes' calendaryear returns during the past 10 years. Each of these factors has and will continue to experience its own unique cycles. Stretches of market-beating performance will inevitably be followed by prolonged droughts. For example, as I discussed in "Value Investors Are Vexed" in the January ETFInvestor, the value premium is in the midst of a decade-plus dry spell during which it has lagged growth by a wide margin. Value has been missing for so long that it's likeness is being printed on the back of milk cartons. But Factors Are Cyclical A stretch of good performance inevitably will be followed by droughts. 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 27.92 19.43 -29.68 41.35 17.70 7.29 16.34 29.66 11.37 5.16 25.59 16.22 -33.84 34.26 16.11 4.21 16.07 27.92 8.45 4.06 22.99 9.04 -37.49 32.56 15.78 3.89 15.83 27.06 6.55 3.71 21.61 6.53 -40.20 32.47 12.03 3.84 14.08 26.68 6.15 -0.55 20.49 6.35 -40.71 31.89 11.76 -3.37 13.60 25.95 4.94 -0.87 20.07 5.99 -42.24 29.99 11.27 -5.54 13.05 23.25 2.94 -1.51 18.74 5.82 -42.95 16.43 10.70 -8.73 12.24 21.91 2.48 -3.20 16.21 5.52 -42.98 14.21 6.29 -9.75 8.06 18.61 2.36 -4.11 p MSCI World Equal Weighted NR USD p MSCI World High Dividend Yield NR USD p MSCI World Minimum Volatility NR USD p MSCI World Momentum NR USD p MSCI World Quality NR USD p MSCI World Risk Weighted NR USD p MSCI World Value Weighted NR USD p MSCI World NR USD Source: Morningstar. One data point I have included in E X H I B I T 1 that is also useful as a crude proxy for this cyclicality is each factor variant's tracking error relative to the cap-weighted MSCI World Index. The idea here is that the further, on average, the performance of each factor index strays from that of its parent, the more discomfort an investor might experience. If past behavior is any guide (I think it is), then discomfort will often lead investors to abandon sound strategies at precisely the wrong time. Owning a proven factor on a stand-alone basis has the potential to deliver better risk-adjusted returns relative to owning the market, but it's hardly a free lunch. Bouts of underperformance can lead to buyer's remorse, which in turn can create the very real risk of bad investor behavior. EXHIBIT 3 Getting the Chemistry Right As these trailing correlations show, some factors are better complements to each other than others. 1 2 3 4 5 6 7 MSCI World Minimum Vol (USD) NR USD MSCI World Quality NR USD 0.88 MSCI World Momentum NR USD 0.84 0.87 MSCI World Risk Weighted NR USD 0.94 0.91 0.88 MSCI World NR USD 0.91 0.97 0.88 0.96 MSCI World Equal Weighted NR USD 0.89 0.91 0.86 0.99 0.97 MSCI World High Dividend Yield NR USD 0.94 0.92 0.84 0.95 0.95 0.93 0.9 0.94 0.85 0.97 0.99 0.98 MSCI World Value Weighted NR USD 0.96 Source: Morningstar. Data from 07/01/2001 to 06/30/2016. Better Together Value, momentum, size, quality, low volatility, and dividends are members of my factor "A-Team." In my mind, value and momentum are the John "Hannibal" Smith and Bosco Albert "B.A." Baracus of factors. The former is the battle-tested leader of the group, cool under pressure and known to enjoy "cigar butts." The latter is known for being unpredictable and having a short fuse. Each member of this factor A-Team contributes its own unique and complementary talents in a team setting. The key to getting the chemistry right is sensible diversification-pairing factors that zig with teammates that zag under a given set of market conditions. E X H I B I T 3 is a correlation matrix that shows the trailing 15-year correlations among the factor variants of the MSCI World Index that are also featured in the first two exhibits. It is apparent that some factors, measured strictly in terms of their historical correlations, are better complements than others. Value and momentum are like peanut butter and jelly. Meanwhile, value and dividend yield are like peanut butter and cashew butter. global.morningstar.com/Morningstarmagazine 57 http://global.morningstar.com/Morningstarmagazine

Table of Contents for the Digital Edition of Morningstar Magazine - October/November 2016