What Is a Factor ETF?

Factor investing is an investment strategy that involves selecting securities based on specific characteristics, or factors, that have historically been associated with higher returns or lower volatility. Factor investing is often implemented using index funds or ETFs that are designed to track specific factor-based indexes. 

In this article, we explain what factor ETFs are, how they work and examples of ETFs that use any of several factor-based strategies. 

What Is a Factor ETF?  

A factor ETF is an exchange-traded fund that invests in companies that exhibit certain characteristics or factors. These factors can include things like value, growth, momentum, volatility and more. Sometimes called smart beta ETFs, factor ETFs use quantitative models to identify and select companies that meet specific criteria related to these factors. 

For example, a value factor ETF might focus on companies that have low price-to-earnings ratios or high dividend yields, while a momentum factor ETF might invest in companies that have shown consistent upward momentum in their stock prices over time. By targeting these specific factors, factor ETFs aim to provide investors with exposure to different investment styles and strategies. 

How Do Factor ETFs Work? 

Factor ETFs work by using a rules-based approach to selecting and weighting their investments. This means that the ETF will have a set of specific criteria that it uses to identify companies that meet its desired factor profile. Once these companies are identified, the ETF will then weight them based on their importance to the desired factor. 

For example, if a value factor ETF is looking for companies with low price-to-earnings ratios, it might weight companies with the lowest ratios more heavily in its portfolio. This weighting approach allows factor ETFs to tilt their holdings toward companies that exhibit the desired factor, while still maintaining a diversified portfolio. 

What Are the Types of Factor ETFs? 

There are many types of factor ETFs but the main factors are based on value, momentum, quality and low volatility. Some factor ETFs combine multiple factors. 

The main types of factor ETFs are: 

• Value-based: Value-based factor ETFs select securities based on metrics such as price-to-earnings ratio, price-to-book ratio and dividend yield. 
• Momentum-based: Momentum-based factor ETFs select securities based on their recent performance and the strength of their upward trend or momentum.  
• Quality-based: Quality-based factor ETFs select securities based on metrics such as return on equity, debt-to-equity ratio and earnings stability. The ETF may then assign quality scores and weight the allocations accordingly. 
• Low-volatility-based: Low-volatility-based factor ETFs select securities with low levels of volatility or risk. The ETF may then weight the selected securities based on their volatility scores.  
• Multifactor: Multifactor ETFs use a combination of two or more of the above factors to construct a portfolio.  

Are Factor ETFs Actively Managed? 

Factor ETFs are generally not actively managed, but some of them do incorporate active investing methodologies to implement their strategies. For example, the rules-based methodologies and weighted compositions of factor funds allow more frequent analysis and rebalancing than the typical passively managed fund. Thus, some factor ETFs incorporate a combination of active and passive strategies. 

Examples of Factor ETFs 

Factor ETFs are exchange-traded funds that invest in stocks based on certain quantitative characteristics or factors, such as momentum, quality and low volatility. The largest factor ETFs vary depending on the market conditions and investor preferences, but here are some examples of factor ETFs with high relative AUM as of March 22, 2023: 

• iShares MSCI USA Quality Factor ETF (QUAL): This ETF invests in U.S. large and midcap stocks with strong profitability, stability and earnings quality. It has over $23 billion in AUM and an expense ratio of 0.15%. 
• Pacer U.S. Cash Flows Cows 100 ETF (COWZ): This ETF provides broad-based U.S. large cap equity exposure with the investment thesis that higher free cash flow is a mark of stability. COWZ has over $11 billion in AUM and an expense ratio of 0.49%. 
• iShares MSCI USA Momentum Factor ETF (MTUM): This ETF invests in U.S. large and midcap stocks with strong momentum, meaning they have exhibited strong recent performance. It has approximately $10 billion in AUM and an expense ratio of 0.15%. 
• Vanguard U.S. Value Factor ETF (VFVA): This ETF seeks to produce higher returns than the broad U.S. market by selecting companies that exhibit lower relative prices in comparison to their fundamental values. VFVA has over $580 million in AUM and an expense ratio of 0.13%. 
• Vanguard U.S. Momentum Factor ETF (VFMO): This ETF follows a rules-based, quantitative approach to offer high momentum exposure to U.S. equities of all sizes. VFMO has over $270 million in AUM and an expense ratio of 0.13%. 

Note that these are just a few examples of the largest factor ETFs, and there are many others available in the market that target different factors and markets.  

Benefits and Risks of Investing in Factor ETFs 

There are several benefits of investing in factor ETFs, including potential for higher returns. However, these unique funds present risks, such as complexity, that investors should consider before investing. 

Benefits of Investing in Factor ETFs 

• Potential for higher returns: Factor ETFs are designed to outperform traditional market-cap-weighted index funds by using alternative weighting schemes based on factors that have been shown to generate excess returns over the long term.  
• Diversification: Factor ETFs allow investors to diversify their portfolio by investing in a broad range of assets that represent a particular factor. This can help to reduce market risk compared to investing in a small number of individual stocks. 
• Low cost: Factor ETFs are generally cheaper than actively managed funds because they are passively managed, meaning they simply track an index. This makes them a cost-effective option for investors who want to invest in a specific factor. 

Risks of Investing in Factor ETFs 

• Concentration: Factor ETFs can have a higher concentration of stocks in a particular sector or region than traditional broad-market ETFs. This can increase the risk of losses if that sector or region experiences a downturn. 
• Lack of customization: Factor ETFs are designed to track an index and cannot be customized to meet individual investor needs. This means that investors may not be able to invest in assets that they consider important to their investment strategy. 
• Complexity: Factor ETFs can be more complex than traditional broad-market ETFs. This complexity can make it difficult for investors to understand how the ETF is investing their money and may lead to unexpected losses. 

Bottom Line 

Factor ETFs can offer a range of benefits to investors, including potential for higher returns, diversification and low cost. However, investors should be aware of the risks, such as concentration and complexity, associated with investing in these types of ETFs. As with any investment, it is important for investors to do their due diligence and understand the risks before investing in factor ETFs.