Factors to Consider When Looking Into Smart Beta ETFs | ETF Trends

As investors consider incorporating smart beta exchange traded funds into a diversified investment portfolio, it is important to look at foundational concepts and the innovative approaches to make a more informed decision in factor allocation.

On the recent webcast, Factor Investing 101: An Actionable Guide for Every Investor, Matthew Cohen, Senior ETF Specialist, Principal Global Investors, outlined the growth of smart beta ETF as more investors look to the benefits of the alternative index-based strategies. Strategic beta equity ETFs seen assets grow to $300 billion at the end of 2018, compared to $66 billion in 2012. More investors are targeting these types of ETFs that capture factor returns systematically as many look to increase returns, reduce risk, reduce cost, outperform fundamental managers, substitute passive managers and improve benchmarking.

“If you’re not familiar with strategic beta, it’s simply a way of systematically investing. Managers build a rules-based framework based to capture returns. Because it’s systematic, it’s also low-cost,” Cohen said.

Mustafa Sagun, Chief Investment Officer, Principal Global Equities, explained that smart beta strategies simply cover factors that are drivers of return. For example, many may be familiar with the size and value factor premia.

“Factor investing is not new. We’ve been following factor performance for decades from the Capital Asset Pricing Model in 1964 through the multi factor academic insights of the 1990s to the proverbial ‘Factor Zoo’ in 2011. Academics and asset managers are exploring new ways to tap into returns using factors,” Sagun said.

To be categorized as a factor, it must be academic or theoretically viable, it needs to be persistent, it must be tradable but cannot be arbitraged away fully, and
it must be time varying.

“Not all factor-solutions are the same. This criteria allows you to do proper due-diligence in factors,” Sagun added

The value, quality, momentum, size and volatility factors are among the most well-known equity factors utilized in smart beta ETF strategies. Momentum identifies stocks appreciating in value. Value looks for cheap stocks relative to fundamentals like book yield, earning yield or cash-flow yield, Quality stocks have healthy balance sheets and exhibit steady profitability. Smaller stocks tend to outperform larger stocks over time. Lastly, volatility or low-volatility tilts or overweights stocks that exhibit low volatility.

When investing in these various factors, investors may notice that specific factors may outperform over short-term periods since they will act differently in differing market conditions. No single factor dominates or outperforms when looking at extended periods.

“Each performs differently, which leads many to consider combining them in portfolios for their return and diversification benefits,” Sagun said.

Nevertheless, over the long haul, we find that these various factors are attractive for long-term investors with positive cumulative factor performance. Sagun attributes this long-term outperformance to three characteristics: risk premia or compensation for additional risk, behavioral psychology or irrationality when investing, and market inefficiencies or certain restrictions in the marketplace.

Alternatively, investors may consider combining factors into a multi-factor strategy as a way to drive excess returns and potentially limit individual factor risks to smooth out the ride so to speak.

Investors who are interested in factor-based strategies have a number to choose from. For example at Principal, investors can look to the Principal Contrarian Value Index ETF (NasdaqGM: PVAL), Principal Sustainable Momentum Index ETF (NasdaqGM: PMOM)Principal Shareholder Yield Index ETF (NasdaqGM: PY) and Principal Price Setters Index ETF (NasdaqGM: PSET) for targeted single-factor exposures. Additionally, options like the Principal U.S. Mega-Cap Multi-Factor Index ETF (NasdaqGM: USMC) and Principal U.S. Small-Cap Multi-Factor Index ETF (PSC) incorporate multiple factors.

“Factor indexing can enhance your passive, cap-weighted indexes or traditional fundamental active management. Combining factors – the right factors, the right way – delivers diversification and return benefits,” Cohen added.

Financial advisors who want to learn more about factor investing can register for the Thursday, September 19 webcast here.