Getting a Handle on Factor Based, Smart Beta ETF Strategies

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.