A number of new exchange traded funds that have hit the market are based on customized indexing methodologies that do not adhere to traditional beta index market capitalization weights.
“Non-traditionally weighted strategies, including those based on factors, give investors an increased toolset to better address their objectives and goals,” Christopher Huemmer, Senior Investment Analyst at FlexShares ETFs, Northern Trust, told ETF Trends.
Many see factor-based index funds or smart beta ETFs as a means to provide greater diversification and targeted exposure to market segments to potentially drive improved risk-adjusted returns, or achieve upside while protecting downside dips.
“Factors have been seen as a way to increase diversification,” Huemmer said. “Secondly, technological advancements in data analytics and computing have made concepts that were once only available to select quantitative investment managers available to all investors. Finally, rules-based index strategies and ETFs have served as a perfect complement to the innovation happening in factor investing.”
As investors grow accustomed to traditional market cap-weighted index funds and single factor styles like value or growth investments, more may look to these enhanced multi-factor-based suites that combine multiple market factors, as a means to potentially get a leg up in the market.
“A multi-factor approach combines factors that are low or negatively correlated to smooth the factor cycles and potentially lessen overall volatility,” Huemmer said. “With single factor products the onus was on the investor to decide which factors to choose and how to combine them through multiple funds or strategies. Multi-factor strategies look to do the heavy lifting of implementing several factors through a single product.”
For example, the FlexShares Morningstar U.S. Market Factor Tilt Index Fund (NYSEArca: TILT) tries to provides enhanced exposure to U.S. equities by tilting the portfolio toward long-term growth potential of small-cap and value stocks.
“We believe one of the key tenets that makes FlexShares different is that we tie everything to the fundamental needs and objectives of investors,” Huemmer said. “There is not one magic set of factors that suits every objective.”
Additionally, dividend ETF investors who are seeking stability, along with exposure to the growing U.S. markets, can look to the FlexShares Quality Dividend Index Fund (NYSEArca: QDF), FlexShares Quality Dividend Dynamic Index Fund (NYSEArca: QDYN) and the FlexShares Quality Dividend Defensive Index Fund (NYSEArca: QDEF). The suite includes a group of smart-beta ETFs that focus on both quality and dividends.
“One of our goals was to devise a way to gain confidence that a company’s dividend was well-covered and that the company had the ability to grow that dividend over time,” Huemmer said. “That evaluation of the financial health of the company became our quality factor. The decision to build a strategy that focuses on a lower beta than the market comes from our acknowledgment that some investors prefer the defensive nature of legacy dividend strategies.”
Some investors, though, may see these factor-based investments as a way to time the markets to optimally capitalize on periods when a specific factor is more pronounced. However, as history has shown, it is hard to perfectly time market moves.
“We do not advocate trying to time factors as it is hard to predict the peaks and troughs of the cycle,” Huemmer said. “We recommend that investors take a strategic view and stay invested in a factor through periods of underperformance so that they can profit during periods of outperformance.”
Looking ahead, the markets are anticipating greater penetration of factor based strategies in the fixed-income space, similar to what happened with equity ETFs. Bond ETFs may start to track customized indices that incorporate market liquidity constraints, specific levels of duration or credit scoring models.
“The role of factors in fixed income is still evolving. Similar to what has evolved in the equity world, non-traditionally weighted strategies may help advisors better meet the needs of their clients,” Huemmer added.
For more information on factor based strategies, visit our smart beta category.