ETF Trends
ETF Trends

By Joe Smith, CFA, CLS Investments

Factor investing is all the rage, but many financial advisors are still unsure of its benefits. Factors such as value, momentum, size, minimum volatility, and quality are well-documented as robust and persistent across markets over time. Advisors and investors alike must now determine how to harness some of the latest ETF innovations to deliver better outcomes in their portfolios.

While there are many academic studies available, there is still much to be understood in regards to the key selling points and long-term benefits of incorporating factor investing into broader investment portfolios. Below is a quick look at a few strategic reasons advisors should consider making the move into factor-based ETFs.

#1. Factors can provide a greater edge over the markets than asset classes or sectors.

Finding and maintaining an edge over the market is a cornerstone principle in financial advising. Most approaches to beating the market have historically focused on either making top-down or bottom-up decisions versus the benchmark using traditional asset classes or sectors. These approaches are used to help investors participate in segments of the market that deliver superior risk-adjusted returns.

When compared to these other methods, factors offer better odds to beating the markets over time. According to a recent study by CLS, individual factors tend to outperform the markets 62% of the time on average, while asset classes and sectors only do this roughly 53% and 52% of the time respectively. When combined into an equal-weighted mix, factors outperform almost 80% of the time, while equal-weighted mixes of asset classes and sectors only do so 51% and 67% of the time respectively.

returns-vs-odds-js-01

Sources: FTSE/Russell, MSCI, Morningstar Direct, and CLS Investments. Performance versus MSCI All Country World Index for Russell 3000 Index and MSCI Indexes. Multi-asset, multi-sector, and multi-factor portfolios are equal-weighted mixes of asset class, sector, and factor index components. As of June 30, 2017.

#2. Factors can provide better downside protection and diversification when it matters most.

The ability to protect on the downside is another important element of effective money management. As markets become turbulent time and again, the ability to protect wealth in order to recover sooner is essential to being able to meet the long-term goals of investors.

Factors can deliver more meaningful downside protection when global equity markets are lower. Looking at average one-year returns when markets have historically been lower, we see that an equal-weighted mix of factors has outperformed the market on average by about 4.4%. An equal-weighted mix of sectors has typically outperformed the market, but only by 2.7%, while an equal-weighted mix of asset classes was on par with the market.

downside-vs-odds-js-01

Sources: FTSE/Russell, MSCI, Morningstar Direct, and CLS Investments. Performance versus MSCI All Country World Index for Russell 3000 Index and MSCI Indexes. Multi-asset, multi-sector, and multi-factor portfolios are equal-weighted mixes of asset class, sector, and factor index components. As of June 30, 2017.

#3. Factors can deliver superior risk-adjusted returns over time.

Nothing is rewarded in life without some amount of risk. This is especially true when it comes to investing. As investors think about their choices, choosing an approach that helps portfolios grow without taking on too much risk can be the difference between long-term success and failure.

Related: Should You Replace Your Active Manager with a Smart Beta ETF?

Not only can factors deliver meaningful positive excess returns over time, much of the excess returns are still there after adjusting for the inherent risk. We find equal-weighted mixes of factors historically have delivered more superior risk-adjusted excess returns over time by a whopping 2.2% over the market. This pales in comparison to just 0.7% of risk-adjusted excess return for an equal-weighted mix of sectors and -0.7% risk-adjusted excess return for an equal-weighted mix of asset classes.

excess-return-js-01

Sources: FTSE/Russell, MSCI, Morningstar Direct, and CLS Investments. Performance versus MSCI All Country World Index.  Multi-asset, multi-sector, and multi-factor portfolios are equal-weighted mixes of asset class, sector, and factor index components. As of June 30, 2017.

Bottom line: Advisors should consider the benefits of adopting factor-based ETFs.

As advisors evaluate new opportunities to deliver long-term diversification and returns in client portfolios, the analysis above highlights tangible support for the use of factor investing in portfolios. We believe factors help get to the heart of the ongoing challenge of maintaining a strategic edge over markets in the long run. What’s even better is factor investing provides an edge with unique risk mitigation considerations not available through traditional asset class or sector-based investment approaches. If advisors have not taken a deeper look at factor-based ETFs, the evidence is too compelling now not to do so.

Joe Smith, CFA, is a Senior Market Strategist at CLS Investments, a participant in the ETF Strategist Channel.

Disclosure Information

This information is prepared for general information only. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. All opinions expressed herein are subject to change without notice. The graphs and charts contained in this work are for informational purposes only. No graph or chart should be regarded as a guide to investing. 2734-CLS-7/13/2017