When targeting a specific investment factor, don’t assume that all ETFs are built the same
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Some advisors might think that selecting a factor ETF to add to their client’s portfolio only involves figuring out the most suitable factor — value, momentum, low-volatility or something else. But in reality, factor index ETFs are much more nuanced.
“It might be logical to think that because some are characterized as ‘indexes’, factor strategies should perform similar to one another,” said Doug Grim, senior investment strategist in Vanguard Investment Strategy Group, in a column for ETF.com. “However, factor indexes can vary greatly, even those that have similar names and/or investment strategies.”
He explained that targeting a particular factor exposure involves numerous active decisions, which are made by most index providers when constructing the index for a factor fund. Value funds, for example, may have different definitions of “value” that deviate from the commonly metric of low price-to-earnings ratios.
“As a result, even though a fund can technically be an index fund, the index itself is an active strategy,” he said. To illustrate, he noted that different value indexes constructed by different providers — CRSP, MSCI, FTSE Russell, and S&P — varied in their historical performance, with 2017 returns ranging from around 8% to over 20%.
That means advisors with a specific factor in mind still have to decide on a specific investment vehicle. To that end, Grim recommended asking four key questions:
- What metrics are used to represent the factor? Whether it’s price-to-book, price-to-earnings, or something else, advisors should consider the supporting evidence to suggest that the metrics employed sensibly capture the style factor.
- What is the weighting scheme (i.e., the construction methodology)? The eligible universe, the frequency of rebalancing, the degree of diversification within the strategy, and the degree to which the factor determines a stock’s weighting are just some considerations.
- How is the factor strategy implemented? Advisors also have to examine whether a factor ETF is actively managed or index-based, as well as make a judgment on the asset manager’s experience with the strategy and any expected turnover.
- What are the expected all-in costs? Expense ratios, taxes — assuming the fund will be held in a taxable account — transaction costs, and premiums/discounts should also be noted.
“The bottom line is: Before selecting which factor product to buy out of all the available choices, do your homework,” Grim said. “Extensive due diligence is necessary (including if it seeks to track an index).”
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