What Are Factor ETFs and How Do They Operate?

Exchange-Traded Funds (ETFs) are popular investment vehicles, offering diversification and accessibility through a single security that trades on stock exchanges. Factor ETFs are a specialized type of fund that aims to capture specific drivers of return within the market, moving beyond traditional market-capitalization weighting. These funds are designed to potentially enhance returns or manage risk by focusing on particular characteristics of securities.

Understanding Factor Investing

An investment factor is a characteristic of securities that has historically been associated with differences in risk and return. These factors represent broad, persistent drivers of returns across various asset classes. The academic origins of factor investing can be traced back to the 1960s with the Capital Asset Pricing Model (CAPM), which initially suggested that only market risk, or “beta,” explained a stock’s returns. However, researchers later found limitations in CAPM, leading to the development of more comprehensive models, such as the Fama-French three-factor model, which added size and value as additional factors to market risk.

The concept of “factor premiums” arises from the idea that certain factors may offer a risk-adjusted return above the broader market. This premium is the extra return an investor can expect for taking on specific types of risk or exploiting market inefficiencies. Some factors may generate additional returns because they involve bearing risks that other investors are unwilling to take, or they might capitalize on investor behavioral biases.

How Factor ETFs Operate

Factor ETFs apply factor investing principles within an Exchange-Traded Fund structure. Unlike traditional market-capitalization-weighted ETFs that simply track an index by holding securities in proportion to their market value, factor ETFs actively select and weight securities based on their exposure to specific factors. This approach allows these funds to “tilt” their portfolios towards companies exhibiting desired characteristics.

These ETFs employ a rules-based methodology for portfolio construction. The fund provider first identifies the specific factor or factors they intend to target. Next, a systematic screening process is used to identify securities that strongly exhibit these chosen factor characteristics. For example, a value factor ETF might screen for companies with low price-to-earnings ratios, while a low volatility ETF would seek stocks with stable price movements.

Once identified, these securities are then weighted in the portfolio according to their importance to the desired factor. This weighting emphasizes the factor exposure rather than just the company’s size. Factor ETFs regularly rebalance their holdings to ensure the portfolio remains aligned with the factor criteria, which can occur periodically. This systematic process aims to provide consistent exposure to the targeted factors, blending aspects of both passive and active management.

Common Investment Factors

Several investment factors have been identified for their potential to influence returns:

• Value: Focuses on investing in stocks that appear inexpensive relative to some measure of their fundamental worth. This typically involves looking at metrics like low price-to-earnings (P/E) ratios, price-to-book (P/B) ratios, or high dividend yields.
• Momentum: Identifies stocks that have shown strong recent performance, with the expectation that this trend will continue in the short to medium term. Momentum strategies involve buying past winners and selling past losers.
• Quality: Seeks to identify companies with strong financial health and stable earnings. This typically involves analyzing metrics such as high return on equity, low debt-to-equity ratios, and consistent earnings stability.
• Size: Often associated with small-cap stocks, suggesting that smaller companies tend to outperform larger companies over long periods. Investors aiming for size exposure would tilt their portfolios towards companies with relatively smaller market capitalizations.
• Low Volatility: Targets stocks that exhibit lower price fluctuations compared to the broader market. The rationale is that these more stable securities may provide a smoother investment experience and potentially offer competitive risk-adjusted returns by mitigating downside risk.