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.
When combining multiple factors, an ETF may take an additive or multiplicative approach. An additive approach would just equally weight the various factors, but this approach runs the risk of diluting factor exposure. The multiplicative approach would overweight stocks that tend to exhibit the stocks with the combined various factors, which may lead to more concentrated factor bets.
“Ensure that your final choices are relatively uncorrelated so that needless factors aren’t included,” Bush said.
In a survey of financial advisors on the webcast, 36% view historical performance of the strategy as the most significant point when evaluating multi-factor strategies while 53% indicated that clarity of the underlying investment process was more important.
Since individual factors may exhibit different returns over the same time period, investors have opted to combine the factors to diversify risk.
“Our research indicates that investors could have outperformed the benchmark by obtaining well diversified exposure across all five factors,” George Rector, ETF Consultant at Deutsche Asset Management, said, referring to the momentum, volatility, value, quality and size factors.
Multi-factor-based index ETF strategies, like the Deutsche X-trackers Russell 1000 Comprehensive Factor ETF (NYSEArca: DEUS), Deutsche X-trackers FTSE Developed ex US Comprehensive Factor ETF (NYSEArca: DEEF), Deutsche X-trackers Russell 2000 Comprehensive Factor ETF (NYSEArca: DESC) and Deutsche X-trackers FTSE Emerging Comprehensive Factor ETF (NYSEArca: DEMG), help limit correlation and diversify a portfolio to better handle changing conditions over longer periods.
“Although academic research has identified factors that are important in explaining a stock’s risk and performance it does not discuss how exposure to these factors could be timed effectively,” Rector said. “In the absence of compelling evidence around timing individual factor strategies, investors may consider using a diversified approach.”
Financial advisors who are interested in learning more about smart beta, factor-based ETF strategies can watch the webcast here on demand.