Anyone can target a myriad of specific asset categories and sub-classes, but among smart beta exchange traded fund offerings, investors may be exposed to various factors as factors are not mutually exclusive.
“In the factor world, a stock can exhibit both value and momentum; or it can exhibit quality and low volatility and size. Just because it has one characteristic doesn’t necessarily preclude it from having another,” Rob Bush, ETF Strategist at Deutsche Asset Management, said in a note.
With the various factors out there, which can define equities across across various parameters, individual stocks can exhibit multiple features. Consequently, investors may have the best of both worlds, gaining exposure to two factors for the price of one investment.
“Investors can, if they so desire, both have their cake and eat it too (i.e. both have their value and their momentum – eating them is inadvisable),” Bush quipped.
Consequently, Bush advised investors to take a three-step framework when determining the “right” number of factors to consider as the right amount is ultimately a subjective decision from investor to investor.
Specifically, smart beta investors should identify those factors that they believe which they want exposure to; acknowledge that they are complementary and that pairs amongst them are not so highly correlated that including both would be unnecessary; and consider the methodology for combining the factors.
To start off, five academically-backed and historically-tested factors include value, size, momentum, quality and low volatility. These various factors found in many smart beta ETFs have undergone extensive empirical tests to show a history of long-term outperformance.
When analyzing the five factors, Deutsche Asset Management found two important features: First is the relatively uncorrelated nature of most of the pairs of factors. Secondly, there are stocks available that exhibit both characteristics, “confirming our earlier point about the non-mutually exclusive nature of factors.” Bush added.
Consequently, investors are ultimately left with a decision based on their risk tolerance. Too few factors risks leaving strong incremental drivers of equity returns left to chance while too many factors risks additional complexity for the sake of marginal excess return.
“Pick factor exposures that you believe in, and be aware of the trade-off between having too few, and having too many,” Bush said. “Ensure that your final choices are relatively uncorrelated so that needless factors aren’t included.”
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