Index Factor Considerations When Selecting a Smart Beta ETF

As smart beta exchange traded funds that track customized indices screening for specific factors grow in popularity, more investors are taking a closer look at the factor-based ETFs to see if the strategies fit with their investment goals.

“Factor investing combines the best features of active, passive and alternative approaches,” Abby Woodham, ETF Strategist for Deutsche Asset Management, said on the recent webcast, Gimme five – five key questions for factor investors.

Factor investing combines low-cost, systematic approach found in passive investments with research driven benchmark outperformance found in actively managed portfolios and cutting edge alpha capture in alternative strategies.

“Individual factors have outperformed the market over the long-term on a  risk-adjusted basis,” Rolf Agather, Managing Director of North America Research at FTSE Russell,

Single factor-based, smart-beta ETF strategies can be used to target specific long-term risk premia. Traders have often used single factor ETFs to tactically increase or decrease exposure to a desired factor or rotate out a factor exposure in a changing market environment. For instance, over the 15-year period ended January 2016, the Russell 1000 Volatility Factor Index has exhibited the lowest volatility among various popular factors but was among the worst performers while the Russell 1000 Illiquidity Factor Index outperformed but exhibited high volatility.

Robert Bush, ETF Strategist for Deutsche Asset Management, explained that good factors should provide higher risk-adjusted returns over the long run that are economically meaningful, persistent and have intuitive economic rationales. For instance, an investor may look at the Sharpe ratio as a determinant, with a higher measure reflecting a portfolio investment’s higher risk-adjusted return.

There are now a number of single factor and multi-factor ETFs available, which may leave investors wondering which is right. However, the “right” number of factors is subjective, so investors will have to determine for themselves if those factors are factors one believes in and want exposure to, the factors complement a portfolio and won’t increase correlation among holdings, and the methodology in combining multiple factors makes sense.