[The following "ETF Industry Perspective" is sponsored by Nasdaq]
Factor investing has been hugely popular in the past few years, with multifactor investing moving to the forefront in the last 18 months or so. Factor investing relies on identified factors that research has shown to be major drivers of returns. Multifactor approaches arose as investors realized the benefits of diversification that come with multiple factors.
In general, a single-factor approach can cause an index to outperform the broad, cap-weighted market over the long term, but different factors perform differently. By using multiple factors, the index's behavior becomes a bit steadier, and hopefully the outperformance of the cap-weighted benchmark becomes a bit more consistent as a result.
With sectors, the alternative weighting offered by a factor-based approach means that diversification is ostensibly improved. In a cap-weighted broad index, a component with a large market capitalization can dominate the weightings. When one drills down to the sector level, that single large-cap name can completely overwhelm the other companies in the sector. Weighting an index by something other than size means that other metrics, like momentum or value, can then take precedence.
A cap-weighted approach gives the most weight to the largest companies. Further, it is the nature of cap weighting to buy when a company's stock is high and sell when that stock is low.
By selecting and weighting components based on their factor exposures, a factor-based methodology could help avoid those names from a weight perspective.
Rather than targeting broad sectors, the new Nasdaq Smart Sectors focus on subsets of sectors like pharmaceuticals and banks. The idea is to achieve smarter and better sector exposures through the factor approach, with the goal of lower volatility and better returns. The methodology targets the price to cash flow, momentum and low-volatility factors, and also includes a liquidity screen that is designed to accommodate large-scale assets. The use of these three factors targets value, growth and volatility, which are big drivers of returns historically.
"We brought in those factors that we know help performance and, over time, do something that helps generate a little bit better performance than the core benchmark itself,” said Dave Gedeon, head of Research and Development, Nasdaq Global Information Services.
"We’re not just looking at that pure momentum; we’re complementing that by focusing on stocks that have high momentum but are generally lower in volatility. It’s a nice sweet spot to be in, and now they have value characteristics. So, again, we look at all three really complementing each other. That’s why we’re calling them ‘smart.’ We think it’s a really smart way of getting access to particular names within a sector,” he added.