Factor ETFs: Meaning, Effectiveness, Examples

What Are Factor ETFs?

Trackers and exchange-traded funds (ETFs) that pursue a simple, passive strategy of following a specified market or index have become extremely popular in recent years, as it has become common knowledge that classic stock picking does not always work.

A pure tracker that entails “buying a market,” such as the S&P 500 or the FTSE in the U.K., has its disadvantages. Although highly transparent, investors are completely exposed to the market in question and all its vicissitudes. It is not surprising, therefore, that hybrid models have emerged that are still tracker ETFs but are deliberately biased in one or more respects. These are often referred to as “factor ETFs.”

Understanding Factor ETFs

The concept behind a factor ETF is that by shifting away from “plain vanilla” trackers, one can improve the rate of return and/or risk level without getting into expensive and time-consuming stock picking. This shift is referred to as “bias” or “tilt.” In other words, these products are not pure trackers; they deviate to some degree from simply going up and down with the specified market.

The following factor ETFs demonstrate how these vehicles operate:

• iShares MSCI USA Size Factor ETF (SIZE)
• iShares MSCI USA Momentum Factor ETF (MTUM)
• iShares MSCI USA Value Factor ETF (VLUE)

Each iShares ETF has a particular tilt, one biased toward small firms, another toward firms whose stock value is accelerating in price or gaining momentum, and a third toward stocks that may be undervalued by the market.

The size factor ETF from iShares focuses on U.S. large- and mid-capitalization stocks "with relatively smaller market capitalization" with the idea that smaller firms tend to be overlooked. The momentum factor ETF invests in stocks with accelerating price and volume, while the value factor ETF weights securities according to four accounting variables and compares these to the parent index.

These three approaches “tilt” the fund away from exposure to your chosen index. These forms of bias all make financial sense, and if properly tuned, should provide a good quasi-tracker, but one that can outperform a pure buying-the-market vehicle.

How Effective Are Factor ETFs Likely to Be?

These ETFs are fairly new, so there is not much of a track record. However, the logic is sound enough that a prudent investment could pay off. Make sure that you understand exactly how the products work. The more an ETF deviates from the pure index (benchmark risk), the more appropriate it may become for sophisticated and active investors.

There are various ways of using these concepts in practice. Atlas Capital, founded by Jonathan Tunney, CFA, in San Francisco, has offered a variant of the concept, “enhanced indexing". In separately managed accounts for large dollar amounts, it uses value, size, and momentum, as well as a short-term reversal. This latter term refers to return over the prior month, which tends to display negative serial correlation, whereas medium-term momentum displays positive serial correlation.

The Atlas portfolios use the four mentioned traits as their factors for enhanced indexing, which they combine into a unified strategy. In other words, Atlas does not actually use the ETFs described above in their pure form but instead has adapted the concept to its own portfolio of stocks.

Atlas founder Tunney says the firm's factor model process enables it “to provide clients with portfolios that are liquid, transparent, low-cost, and backed by years of academic research." Factor ETFs reduce the costs of traditional actively managed funds by providing a low-cost product that's still well-researched and can provide greater-than-market returns, he says.

These products are generally recommended, by the people offering them, for investors who seek exposure to other and different risk factors and “alternative beta.” Nonetheless, until they gain acceptance, the factor ETFs face liquidity issues.

Some Other Examples of Factor ETFs

Plenty of other factor ETFs are in the market, as they include any common market-wide drivers of security return.

For example, Fidelity offers 15 factor ETFs across geographies and asset classes (including Domestic Equity ETFs, International Equity ETFs, and International Equity ETFs). Fidelity's factor ETFs aim to provide exposure to the desired factor while minimizing risk. The latest Fidelity U.S. Multifactor ETF (FLRG) targets U.S companies with strong exposure to value, quality, low volatility, and momentum factors with constrained exposure to the size factor.

FlexShares, the ETF unit of Northern Trust, also has funds based on a multi-factor model approach intended to provide a heavier emphasis on international small caps and value stocks. The products are the FlexShares Morningstar Developed Markets Ex-U.S. Factor Tilt Index Fund (TLTD) and the FlexShares Morningstar Emerging Markets Factor Tilt Index Fund (TLTE).

The Bottom Line 

ETFs and trackers are here to stay, given that it is pretty much accepted that paying someone to simply “beat an index" can be counterproductive. Pure trackers have their disadvantages, however, as there is no protection from market movements. New factor ETFs offer some compromise with a bit of "tilt" away from an index. If you are more experienced or adventurous, factor ETFs may make sense as a form of diversification and a potential means of enriching your portfolio.