Are Traditional Factor-Based Strategies Vulnerable to More Downside Than Investors Think

Traditional factor-based strategies are vulnerable to more downside than investors think – that’s according to Ted Theodore, CFA, Portfolio Manager of the TrimTabs Float Shrink ETF (TTAC).

Theodore argues that Smart Beta ETFs have lulled investors into a false sense of security because they fall short of protecting against “financial engineering” risk.

ETF Trends spoke with Theodore about his theory that factor-based strategies may be vulnerable if there is a serious sell-off.

ETF Trends: Can you elaborate on the dangers of “financial engineering” risk and why Smart Beta ETFs can’t help to protect investors from it?

Theodore: These are two separate issues. Financial engineering today arguably is most related to the practice of companies who like the impact of a reduced share count on their earnings per share, sales per share and on.

However, when those share reductions happen because the company has borrowed money to pay for the repurchases, then the company is “engineering” only a cosmetic change, and one which carries the increased possibilities of danger if the condition of its balance sheet deteriorates materially. Except for ETFs that specifically target buybacks, Smart Beta ETFs are only indirectly affected by this kind of financial engineering.

However, since the clear majority of buybacks are financed with debt and it is a widespread practice, any adverse change in the interest rate or economic environment can introduce a risk to any ETF that was not contemplated.

ETF Trends: Can you explain why traditional factor-based strategies are vulnerable to more downside than investors think?