What You Should Know About Factor ETFs

May 26, 2016

Factor investing is all the rage today.

ETFs like the iShares Edge MSCI Min Vol USA ETF (USMV | A-69) have gathered billions of dollars in assets this year, a trend that may just be getting started.

USMV's $5.3 billion haul leads the pack, but other ETFs focused on different factors are also taking in big money from investors. We take a look at some of the most popular factors and see how they've been performing.

What Are Factors?
According to index provider MSCI, a factor is simply any stock characteristic "that can be shown to be important ... in explaining risk or returns." There could be thousands of factors, but most do not outperform the market over the long term.

As its name implies, USMV focuses on the "low volatility" factor. Low volatility is one of six factors that, according to a research paper by MSCI, "have historically earned a long-term risk premium." The others are value, low size, high yield, quality and momentum.

Source: MSCI Index Research

Pitfalls Of Factor Investing

It's an open question as to why these outperforming factors exist, and whether they will continue to beat the broader market-cap-weighted market. There are no guarantees that the aforementioned six factors will outperform going forward.

Moreover, even if they do, an investor must have a sufficiently long enough time horizon to capture the risk premium.

Factors are seen as cyclical, with periods of underperformance and outperformance against the broader market. An investor might have to wait a long time―fifteen years or more, according to MSCI―to potentially capture the risk premium associated with a particular factor.

Another pitfall is that, if enough investors pile into a certain factor, that could reduce the risk premium it provides, or eliminate it entirely.

Low-Vol Factor Outperforms In 2016
Despite these dangers, investors are taking their chances with factor-based ETFs. Some of these investors may have a long enough time horizon to see the full factor cycle through.

Others may be simply chasing performance and hoping a recently outperforming factor continues to outperform in the short term.

That may, in fact, be part of the reason for USMV's popularity this year.

We took a look at year-to-date performance for six representative factor ETFs―one for each of the outperforming factors mentioned earlier―and the low-vol fund is at the top of the heap.

(Incidentally, there are many ways that ETFs and their underlying indexes attempt to target a particular factor, which can lead to significantly different returns among various funds targeting the same factor.)

USMV's 6.2% year-to-date gain leads the other ETFs, as can be seen from the table below. For context against the broad market year-to-date, the SPDR S&P 500 ETF Trust (SPY | A-97) is up 2.5%.

Factor ETF YTD Return 1-Year Return 3-Year Return
Low Volatility iShares Edge MSCI Min Vol USA ETF (USMV) 6.4 8.1 37.3
High Yield Vanguard High Dividend Yield Index Fund (VYM) 6.2 3.6 33.2
Low Size Guggenheim S&P 500 Equal Weight ETF (RSP) 5.2 -1.5 33.9
Quality iShares Edge MSCI USA Quality Factor ETF (QUAL) 2.9 2.5 37.3
Momentum iShares Edge MSCI USA Momentum Factor ETF (MTUM) 1.7 4.4 44.8
Value iShares Edge MSCI USA Value Factor ETF (VLUE) 0.9 -5.8 25.3

Perhaps money is flowing into USMV and other low-vol ETFs because they are outperforming, or perhaps they are outperforming because money is flowing in (or maybe a little of both).

In any case, the low-volatility factor is working right now, and that's sure to keep it popular for the time being.

On the other hand, the momentum factor, as represented by MTUM, isn't doing too well this year, but it is the top performer among the group over the last three years.

Contact Sumit Roy at [email protected].

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