Behind Factor ETFs' Popularity

September 11, 2017

Factors are everywhere these days. In the ETF world, factor strategies are not only growing in number, but in assets, as more and more investors look to capture various return streams beyond plain market beta.

Factors are equity risk premiums that historically have delivered outsized returns over time relative to the market.

What Makes A Factor

As Andrew Ang, head of Factor Investing Strategies for BlackRock, told an audience of advisors and ETF industry folks at this year's Morningstar ETF conference in Chicago, what makes a factor a factor—and not just some novel investment idea—is whether it has created value over a long period of time. Has it generated positive risk-adjusted returns historically?

A true factor also “must be based on both strong economic intuition and academic evidence;” it must offer diversification from a plain market-cap exposure to the equity universe; and it must be scalable. Some of the most widely accepted factors include value, momentum, quality, dividend yield, size and low volatility.

“There’s nothing new about factors. What’s new is the way we access them,” Ang said. The proliferation of the ETF wrapper has made factor investing easy, cheap, tradable and totally accessible to anyone in ways that were not possible before.

If the ETF wrapper popularized factor investing, the current economic environment has made it practically go viral.

High Liquidity

Consider this fact: There are more than 345 single-factor ETFs on the market today. That’s roughly 17% of all U.S.-listed ETFs. Together, these funds command more than $500 billion in assets—at least 70 of these single-factor ETFs have at least $1 billion in assets under management. These are big, popular, highly liquid funds.

Some factor products are simple single-factor strategies, while some of them are complicated portfolios that use multifactor selection and weighting schemes to capture a single factor. Their growing popularity centers on three key trends, according to Ang:

  1. A tough economic environment with low yields. This environment has investors looking to “squeeze” extra returns from wherever they can. Factors help with that.
  2. Lessons from the financial crisis show that “old fashioned ways” of constructing portfolios aren’t enough anymore. “Factors are to investments what nutrients are to food.” They are key drivers of return, and in this new era of portfolio construction, they are crucial.
  3. There’s such a thing as alpha. “Factor investing empowers active management.”

Be it to complement other strategies, or to replace more expensive, less efficient strategies, or even to tilt portfolios toward certain factors to express certain views, investors are flocking to factor ETFs.

Think About It

Here’s what to consider if you, too, want to jump onto the factor investing bandwagon, according to Ang.

Factors are cyclical

“Factors vary all the time; they are cyclical just as every other asset class is cyclical,” Ang said. “You need to pay attention to not give up returns through poor portfolio construction.”

There are times when value will underperform, and times when low size will lag large-cap stocks. Factor investing means bracing for periods of underperformance for the sake of a long-term goal.

Correlations matter, so think multifactor

Value and momentum, for example, are typically negatively correlated. When one is doing well, the other is not. You don’t want one factor canceling out the other. And yet, a good mix of uncorrelated factors can result in a better, more resilient portfolio overtime.

“Use a multifactor combination for more consistent, more robust returns that are more resistant to drawdowns,” Ang said.

Rotation is a good strategy

“Harvest cyclicality for returns,” Ang said. “Rotate portfolios according to factors.”

Some of the signals that can help an investor tilt toward one factor or another include valuation; relative strength and short-term momentum of a stock or sector; and dispersion. These can allow investors to disentangle the winners from the losers.

Ample Choices

Investors have plenty to choose from when it comes to factor ETFs. Here’s quick look at some of the biggest funds in the space:

 

Ticker Fund Selection Criteria Weighting Scheme Factor ER AUM
IWF iShares Russell 1000 Growth ETF Multifactor Multifactor Growth 0.20% $36.42B
IWD iShares Russell 1000 Value ETF Multifactor Multifactor Value 0.20% $35.49B
VTV Vanguard Value ETF Multifactor Multifactor Value 0.06% $32.21B
VUG Vanguard Growth ETF Multifactor Multifactor Growth 0.06% $28.80B
VIG Vanguard Dividend Appreciation ETF Dividends Market Cap Dividends 0.08% $24.57B
IVW iShares S&P 500 Growth ETF Fundamental Market Cap Growth 0.18% $19.01B
VYM Vanguard High Dividend Yield ETF Dividends Market Cap Dividends 0.08% $18.81B
DVY iShares Select Dividend ETF Dividends Dividends Dividends 0.39% $16.76B
SDY SPDR S&P Dividend ETF Dividends Dividends Dividends 0.35% $15.35B
USMV iShares Edge MSCI Min Vol USA ETF Multifactor Multifactor Low Volatility 0.15% $13.80B

Data courtesy of FactSet

Contact Cinthia Murphy at [email protected]

 

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