Understanding factor-indexed ETFs

By Barry Gordon and Rohit Mehta | March 14, 2014 | Last updated on March 14, 2014
4 min read

ETFs are staples for advisors in search of better risk-adjusted returns in equity markets. And factor-based index ETFs are designed to capture returns that fall outside traditional market capitalization-based products.

These alternatively constructed ETFs offer focused exposures based on factors affecting equity risk and return: size, value, momentum and volatility.

Factor-based ETFs can also strengthen the core of client portfolios. As a strategy to exploit market anomalies in a rules-based, systematic way, they offer a sweet spot between active management and indices predicated on the accuracy of the Capital Asset Pricing Model (CAPM).

Read: How to manage a bond portfolio

Smart beta, intelligent indexing

Actual market mispricings self-correct, but tracking factors representing true risks creates smart beta that earns premiums for investors.

Factor ETFs use rules-based filters to create a ranked list of stocks from the available market. Selected stocks comprise an index constructed around a factor theme, such as momentum, value or volatility. To capture the small-cap effect, factor indexes can be equally weighted to inject a bias, or to tilt away from large-cap stocks.

A value-themed ETF will use value-oriented metrics to identify stocks from the broad universe of stocks and construct an index based on select criteria. For instance, it could equally weight five factors: price-to-earnings ratio, price-to-cash flow ratio, price-to-book ratio, price to latest four quarters of sales, and three-month earning per share estimates.

Read: UPDATED: Leveraged ETFs small but risky

Other factors could include:

  • trailing return on equity;
  • three-month earnings per share estimate revisions
  • latest quarterly earnings surprises;
  • price change from three months ago to current;
  • price change over nine months;
  • percentage price change from 12-month high.

Factors like these are important in identifying stocks’ value and momentum characteristics.

Advanced screening tools within factor indexes are designed to capture single or combination effects, such as value and momentum patterns from financial data, without interference from human emotion. Automated rules are validated through back-testing done by index providers such as Morningstar and MSCI, and indices are rebalanced (quarterly, semi-annually, annually) to reflect market changes and re-ranking.

While factor-based indexing has its critics, their arguments fail to explain empirical evidence demonstrating the efficacy of factor ETFs in delivering better risk-adjusted returns than cap indices in many markets, including Canada.

Read: Different ways to construct ETF portfolios

MSCI (which also offers market-cap indices) and Morningstar have analyzed decades worth of data and found that factor strategies, especially size and value, generate premiums for investors who tilt their portfolios toward them over the long run. In fact, factor strategies work particularly well in the Canadian market due to structural inefficiencies that provide added exposures.

Advantages for advisors

Factor-based ETFs offer access to strategies that, in the past, were only available to portfolio managers. Furthermore, factor-based ETFs provide the opportunity to earn better risk-adjusted returns than traditional CAPM indices.

They can also be used tactically to help rebalance Canadian portfolios too skewed towards financial services and natural resources. Alternative weighting methodologies naturally avoid the sector biases that creep into cap-weighted indices.

In Canada, investors can diversify their portfolios with factor-based ETFs that tilt away from the standard TSX Composite weights. This is an important strategy to consider when commodities markets are volatile (which impacts TSX Composite returns).

Clients will appreciate that factor-based ETFs are transparent and rules-based. The data is public information and the filter rules are back-tested to show how these strategies have performed in the past. Most index providers make these histories available on their websites, along with all the known data on the stocks within each index.

Factor-based indices typically cost more than cap-weighted because they’re more complicated and expensive to run. But factor-based ETFs should be judged less by traditional criteria, such as tracking error, cost and volume, and more upon their success in delivering the risk-adjusted return profile predicated by the particular factor they aim to get exposure to.

Read: Do equal weight ETFs outperform?

As demand grows for investment alternatives, factor indexing may converge with sector or sub-market indexing to create a technology momentum index or an energy value index (which in turn can be replicated in ETFs to provide advisors with additional tools), for instance. When demand is there, someone will build it; and as factor indices gain acceptance, demand will naturally accelerate.

3 Market Myths dispelled

The U.S. economy is gradually improving, says Leith Wheeler president and CEO, Jim Gilliland. But not everyone believes that, he says, because they have fundamental misconceptions about the market. Speaking in Calgary Feb. 20, he outlined three.

Misconception 1: U.S. housing continues to drag the economy.

Reality: According to Gilliland, the U.S. housing market is rebounding. He gives the example of Mountain House, a small town in the San Francisco Bay area. It was one of the country’s worst-hit regions in 2008, but is now a bustling locale where they’re starting to build new houses. “That is a microcosm for what we’re seeing in the overall U.S.”

Misconception 2: Small business, the growth engine of the North American economy, is dead.

Reality: Small business is leading the U.S. recovery, Gilliland says. “They’re more optimistic than they’ve been at any time in the last five years. Bank lending is very healthy, and employment growth for companies with fewer than 50 employees is leading the nation.”

Misconception 3: Government deficits are putting the U.S. on an unsustainable path.

Reality: “The deficit picture in the U.S. has improved dramatically over the last three to four years. The U.S. is now on track for a lower budget deficit than at any time in the last 40 years—lower than the ‘80s, which was the Reagan era.”

– Jacqueline Louie is a Calgary-based financial writer

Barry Gordon is president and CEO of First Asset, a manager of ETFs, mutual funds, and closed-end funds. Rohit Mehta is a senior vice-president at First Asset.

Barry Gordon and Rohit Mehta