Cheaply Incorporating Factors Into a Core U.S. Equity Portfolio

By Mason Wev, CFA, CMT, Clark Capital Portfolio Manager

As academic finance and factor investing have become mainstream parts of the investing landscape, many of the financial advisors that Clark Capital partners with have expressed interest in cheaply and effectively incorporating investing factors into client portfolios. We believe in active management, and we run SMA portfolios that are factor based in their security selection.

Deciding to use factor-based ETFs in our ETF strategies was a natural progression for us. One question advisors have faced has been whether to incorporate factor investing via one multifactor ETF or a portfolio of single factor ETFs.  In this article, we will explain why we favor single factor ETFs and how Clark Capital incorporates factors into its core U.S. equity ETF portfolio (which we call U.S. Equity Strategic Beta).

In our mind, a single factor ETF approach to building a portfolio has two advantages over multifactor ETFs.  One is that you, the investor, maintain control over and the flexibility to change the portfolio’s factor exposures.  The second benefit has always surprised me as an ETF analyst:  multifactor ETFs are often more expensive.  In the large cap space, here are three prominent multifactor or smart beta ETFs, and their expense ratios:

While all of these ETFs are sound long-term products with quite modest (if not ultra-low) expense ratios, by going the route of individual factor ETFs, we find that an investor can further lower expense ratios (all ETFs in our portfolio have expense ratios of 20 basis points or below) while maintaining greater control over the factor and other risks that the portfolio takes.

At Clark Capital, we recognize at least six different investment factors, investable via popular ETFs.  The first factor we included was dividends. While dividends are not always cited as an academic finance factor, they are a key portion of any equity investor’s returns.  Our approach was to emphasize either dividend growers (via iShares Core Dividend Growth ETF [DGRO] – expense ratio:  12 bp) or dividend payers (via iShares Core High Dividend ETF [HDV] – expense ratio 12 bp); to invest in both at the same time would, to us, double-count the factor.  The other five factors we included are established, well-recognized, and are investable via popular ETFs (examples of factors and expense ratios noted below).

  • Value Factor: VLUE (iShares Edge MSCI USA Value Factor – 15 bp)
  • Low Volatility Factor: USMV (iShares Edge MSCI Minimum Volatility USA – 15 bp)
  • Quality Factor: QUAL (iShares Edge MSCI USA Quality Factor – 15 bp)
  • Size Factor: EQAL (PowerShares Russell 1000 Equal Weight ETF – 15 bp)
  • Momentum Factor: MTUM (iShares Edge MSCI USA Momentum Factor – 15 bp)

Along with providing low cost, tradeable vehicles to access them, factors can bring well-established diversification benefits to portfolios that are worth a quick review.  We have internally tested which factors deserve addition to our portfolio by creating a model portfolio that is composed of roughly half traditional indexing and half an equal weighted mix of the six factors that we outlined above.  The model portfolio provided a “proof of concept” – it outperformed our benchmark, the Russell 3000, with a higher hypothetical total return and improved Sharpe Ratio over three, five, and 10 year periods.  What makes adding factors to a portfolio so appealing to us is that the resultant portfolio by design does not make large deviations from the benchmark (Russell 3000), and thus these model returns and risk reductions can be achieved while taking very few active bets versus the benchmark.

SEE MORE: Can We Trust the Cheap Valuations in Emerging Markets This Time?