How Investors Are Using Factors Now

Recently BlackRock released its Factor Box tool, which allows users to search hundreds of mutual funds and ETFs for their exposure to six key factors: value, size, momentum, quality, dividend yield and low volatility. 

It's a powerful tool for financial advisors and individual investors, who can't always access the wealth of research on factor investing available to institutional investors.

ETF.com recently spoke with Holly Framsted, head of U.S. smart beta for BlackRock, to talk about the Factor Box tool, how insurers and advisors differ in their ETF use, and other conversations she's having with clients about factors right now.

ETF.com: We're seeing a lot of issuers slashing prices on their smart-beta ETFs lately. What impact do you see this having on the space moving forward?

Holly Framsted: Price is obviously an important and timely topic in the ETF landscape. But in the case of smart beta in particular, you really should be aware of what it is you're paying for. 

We've spent a lot of time this year thinking through why clients are anchored on fee as their kind of first go-to. And what we've come to is that it's because there aren't very many widespread tools that allow you to fully evaluate factor products. Seeing a particular fund's specific factor exposures has actually been quite difficult for the financial advisor community and home offices within wealth advisories; that's why we created the Factor Box tool. 

ETF.com: Do you find those advisors are using smart beta ETFs to complement vanilla, indexed exposure, or to replace it?

Framsted: A bit of both. I've yet to talk to a client who's selling everything they own and buying a whole portfolio of smart beta. In reality, we tend to see factor [products] complementing both active and passive allocations. Depending on the problem the advisor is trying to solve, they may replace an active manager, or some beta exposure instead, to make that purchase.

That being said, smart beta—like multifactor funds—can be a really important part of the core portfolio. It doesn't have to be on the fringes. Often, you'll see them paired alongside an IVV (iShares Core S&P 500 ETF). Or maybe the client decided that their large growth or value manager is underperforming, so they replace that core exposure with a single-factor or multifactor strategy, and also reduce cost.

ETF.com: Is institutional use of factor ETFs different than retail use?

Framsted: Yes. Institutions have been some of the leading investors in ETF factor strategies. Some large pensions, for example, have restructured their entire portfolios around factor strategies. We're also having conversations with large insurance companies about the benefits of minimum volatility, for example.

But institutional adoption is more nuanced. That's because institutions can access commingled trust funds, separate accounts, and other various structures besides ETFs to leverage factors.

ETF.com: If that's the case, why would they use a factor ETF at all?

Framsted: It depends on the client, but a lot of the institutional use cases for exchange-traded funds generally also apply in the case of factors. For insurance companies, for example, that buy ETFs, the contracting process for a commingled trust fund or an SMA and the associated potential illiquidity aren't what they're looking for. So the liquidity that ETFs provide can be really compelling.

ETF.com: We've seen insurance companies in particular increase their use of ETFs. What are you hearing from insurers on what they're looking for from ETFs?

Framsted: With insurance companies, the conversation most often centers around risk mitigation and their equity allocation. For many insurers, their equity allocation is a higher capital charge. Therefore, they need to be very intentional about how they're spending that capital.

So most start with leveraging minimum-volatility strategies or high-dividend-yielding strategies, because they look similar to bonds, and most of an insurer's general account tends to concentrate in bond portfolios. When they take on equity risk, many insurers don't want to step too far away from that spectrum; but maybe they need to increase their income in a fairly low-yielding environment.

At the same time, we're also seeing insurers think differently about how they can maximize that capital charge they're taking. The thinking goes: If you're going to take a higher capital charge, then you should make the most out of that investment. So then be a bit more aggressive in your equities; ensure you're achieving the maximum potential outperformance for the charges you're taking on. So we're equally having conversations with insurers about the return-seeking end of the spectrum.

ETF.com: Are insurers turning to multifactor ETFs, too?

Framsted: Multifactor is definitely a component of the conversation. In fact, I think it probably fits even more cleanly in the insurance space than with other institutions. If you think about a typical insurance general account, the average insurer allocates something like 12% to equities—but that 12% allocation constitutes a 42% contribution to risk.

Yet many insurers aren't spending much time nuancing within their equity [allocation], because it's a fairly small portion of their book. Therefore, strategies like multifactor are really compelling; they can be the core, and take your broad asset allocation as a one, single-take strategy.

ETF.com: One of the concerns about multifactor ETFs I've heard is that, by combining multiple factors, you aren't getting as precise a factor exposure as you could with just a single-factor fund. What are you getting with a multifactor ETF that you couldn't necessarily get from using single-factor funds individually?

Framsted: If you only buy stocks that are, say, value-oriented, you might invest in companies that are cheap but not trending in the market. And if you only buy momentum companies, you're likely to invest in overpriced stocks that are trending.

But when you pair those two together in a portfolio, the downward-trending value stock trap can potentially offset the expensive momentum exposure you have in the other sleeve—and vice versa. The expensive momentum exposure is mitigating your opportunity to capture value. Pairing the two doesn't necessarily aggregate in the best exposure in the portfolio level.

In our multifactor funds, we're looking for companies that have as many attributes we're seeking as possible, and as few negative exposures to those attributes as possible. So rather than pairing top down and combining individual indices, we're looking for stocks that are simultaneously underpriced and trending with the strongest balance sheet possible and that are generally smaller in nature.

It doesn't mean every stock will have all those attributes. They won't. But a few will in every portfolio. Kohl's (KSS) is a great example of one that's in our large-cap multifactor fund, the LRGF (iShares Edge MSCI Multifactor U.S.A. ETF).

ETF.com: There are literally hundreds of factor ETFs out there nowadays, and they can be tough to tell apart besides price. What sorts of questions should investors be asking themselves to differentiate between funds?

Framsted: I think it's important to understand the problem you're trying to solve. Are you looking for a tool that allows you to make tactical tilts in your portfolio around economic cycles, based on which factors you think will be in favor? Then single-factor funds might be helpful—as long as you understand the strength of the exposure you get in those funds.

Second, you've got to do the due diligence within that genre, like you'd do with active managers. It's not as simple as picking and choosing based on a few metrics from a list. You need to dig deeper. In the multifactor space in particular, you need to understand how the factor exposures within the fund align with your investment objectives.

If, for example, you’re seeking outperformance, you might not want minimum volatility to be one of the factors in your multifactor strategy, since minimum volatility is likely to dampen returns over time at reduced risk. So it's an efficient investment—it's just not a return-seeking investment.

Finally, make sure those factors combine in a way to give you the maximum exposure you seek.

Contact Lara Crigger at [email protected]