Seek unique sources of excess return with Factor-Based ETFs

What is factor-based investing?

Factor-based investing is an approach that targets specific return drivers across investments. Broadly speaking, there are two-factor types:

1. Macroeconomic factors
2. Style-based factors

Macroeconomic factors include the factors that drive return based on overall economic factors, such as:

• Economic growth – exposure to the economic cycle
• Interest rates – exposure to interest-rate movements
• Inflation – exposure to changes in price levels
• Credit – exposure to credit and default risk
• Emerging markets – exposure to developing economies
• Liquidity – exposure to illiquid assets 

Style-based factors include the factors relating to companies, such as:

• Value – exposure to discounted stocks relative to their fundamentals
• Momentum – exposure to stocks with upward price movement trends
• Quality – exposure to companies with strong financial performance
• Growth – exposure to companies that are growing quickly
• Size – exposure to smaller companies
• Minimum volatility – exposure to stable and lower-risk stocks

Why invest in factors?

Factor investing is based upon academic research and is theoretically able to help:

1. Improve portfolio diversification
2. Generate above-average market returns
3. Lower overall portfolio risk

In factor investing, investors will isolate specific factors that have been shown to generate returns historically. 

The diversification provides a benefit in that at least one of the factors should outperform in any given market environment. For example, in an environment characterized by high uncertainty, minimum volatility, quality, and value style factors may have a higher likelihood of outperforming. However, momentum and growth stocks may have a higher probability of outperforming in an environment characterized by low uncertainty and high confidence.

Specific factors are isolated because of their historical track record of generating an excess return, that is, a return above the overall market. Combining this fact with the improved diversification of having exposure to multiple factors, factor investing is a highly viable investment strategy for improving overall returns and smoothing the volatility of returns. 

Furthermore, by using ETFs, investors can gain exposure to attractive factors efficiently and at a relatively low cost. Factor investing utilizes security screens on essential metrics to invest in attractive securities. For example, a Value Factor ETF may screen for stocks with a lower price-to-earnings ratio or a lower price-to-book ratio. Another example is a Growth Factor ETF that may screen for stocks with higher revenue or higher earnings growth. 

Examples of Factor-Based ETFs

Some examples of ETFs that have exposure to Factor-Based investing include:

VLUE (iShares MSCI USA Value Factor ETF)

Summary: Built to track the investment results of an index composed of U.S. large and mid-capitalization stocks with value characteristics and relatively low valuations.

AUM: $9,112M

Expense Ratio: 0.15%

YTD performance: -15.8%

VFMO (Vanguard U.S. Momentum Factor ETF)

Summary: Built to track the investment results of stocks with recent strong performance across a diverse mix of stocks, including small, mid, and large-capitalization stocks. Furthermore, stocks are diversified across different market sectors and industry groups.

AUM: $182M (as of April 30, 2022)

Expense Ratio: 0.13%

YTD performance: -17.6%

FQAL (Fidelity Quality Factor ETF)

Summary: Built to provide investment returns that relate to the performance of the Fidelity U.S. Quality Factor Index, which reflects the performance of large and mid-capitalization U.S. companies with a higher quality profile than the broader market.

AUM: $256M (as of May 31, 2022)

Expense Ratio: 0.29%

YTD performance: -21.5% 

Data for this article is as of June 14, 2022.