When and why to use factor investing

It’s clear that factors have captured the attention of ETF investors looking for a way to add alpha and outperform the broad market.

In the past 20 years, investment managers have identified upward of 200 different factors, which include everything from seasonality to a CEO’s gender. Although there is still debate about how to define a factor, the consensus is that there are five generally accepted factors that have been found to be persistent and repeatable over time: value, momentum, quality, size and minimum volatility.

There are two main reasons for using factor-based ETFs (also called smart-beta or rules-based strategies). Many portfolio managers feel, as I do, that factors can add alpha. Nobel Prize-winning research has shown that over time, some factors can outperform the broad-based market index. If you share this conviction, it makes sense to move beyond a market-capitalization strategy to build investment portfolios.

Rules-based ETFs are also seen as providing active investing at a much lower cost. Fee compression in the ETF space started with the plain vanilla, market-cap strategies, but has made its way into the smart-beta space as well. Indeed, the management expense ratio (MER) of many factor ETFs is between 25 and 30 basis points — far below that of an actively traded mutual fund. If factors can outperform market indices, then accessing this alpha at a lower price increases the probability of higher returns.

When I attended the 2015 Inside ETFs conference in Florida, attendees were told that smart beta would be the next big thing to hit the ETF space. Since then, factor-based strategies have proliferated. Accessing them is no longer a problem, but for many money managers, when to use them is.

Factors perform differently throughout an economic cycle. For example, value has underperformed growth since the Great Recession. For those who do not want to time the market, there are multi-factor ETFs. These products can provide varying exposure to what is deemed by the issuer to be the most important factors in the market to eliminate the need for shifting from one strategy to another as the economic cycle unfolds.

Since I do not believe anyone can successfully time the markets, I think multi-factor has its place as long as you are not also actively trading the underlying strategies.

I use factors to emphasize my particular market convictions; for example, growth versus value. In our more conservative portfolios, I am more inclined to use a low volatility factor-based strategy to help reduce portfolio fluctuation.

In any kind of ETF-based investment portfolio, managers should understand the factor exposures at both the individual product and full portfolio level since you can inadvertently reduce your intended factor loadings. For example, let’s assume a manager wants high exposure to both value and momentum and seeks to achieve that exposure by combing a value ETF with a momentum ETF in equal weights. The challenge is that the value ETF tends to have negative momentum factor exposure and vice versa, so the equal weighted sum of the two together may not have as much value or momentum as the portfolio manager initially expected.

In short, adding a factor-based approach to your portfolio management requires conviction, a strong view of what it is you want to achieve and attention to your performance attribution.