Benefit from active fund styles with factor ETFs

What is factor investing?

Unlike some of the more complex alternatively weighted ETFs on the market, factor ETFs that screen stocks by characteristics including size, value, momentum, quality, volatility and growth are well backed by research. "The most well-established factors have been extensively covered by the literature and there is a clear rationale for their performance," says Ben Seager-Scott, director of investment strategy at Tilney Bestinvest. "Arguably value investing goes all the way back to [famous investor] Benjamin Graham so those principles are well established and persist out of sample too."

<box out> Popular factor ETFs

Value: Stocks whose share prices are depressed compared to their fundamental value and might be mispriced by the wider market.

Growth: Stocks with fast earnings growth. These tend to be in more high-octane parts of the market and tend to be more expensive than value stocks. 

Momentum: Momentum investing involves buying stocks that have performed strongly in the belief that they will continue to perform for at least the short term. Indices use metrics such as recent 12-month share price performance and stock volatility.

Quality: Companies with strong cash flow positions, strong competitive advantages and low levels of debt. 

Size: Smaller companies. Over the long term small-cap stocks tend to outperform large ones due to the fact that they potentially have room to grow. 

Minimum volatility: Stocks with a lower standard deviation than other parts of the market and so a lower risk of erratic share price movements.<boxout>

Different factors perform at different times  

However, different factor ETFs perform at different times and understanding what drives each one is key. In the year to date, the MSCI World Momentum index has returned 11.4 per cent and the MSCI World Growth index has returned 11 per cent, compared with a return of 7.2 per cent for the MSCI World. US-focused momentum ETFs have reflected that too – the iShares Edge MSCI USA Momentum Factor (IUMF) has returned 17.3 per cent in 2017 to date, compared with 4.9 per cent for the MSCI USA index.

Oliver Smith, portfolio manager at IG, says: "The technology rally has been very strong in 2017 and those are the stocks that tend to be held in growth and momentum ETFs." Information technology stocks make up 24.7 per cent of the MSCI World Growth index compared with 16.4 per cent for the MSCI World index.

In the 2016 calendar year, however, investors would have been better off investing in value-flavoured ETFs, which stormed above other factors and outperformed the broader index. Value stocks tend to be those in cyclical sectors such as financials, which have fallen out of favour. These re-rate heavily during interest rate tightening periods and in periods of economic recovery. Value investing has been out of favour for several years amid low interest rates as investors have flooded to perceived safer stocks. But it has enjoyed several sharp rallies since mid 2016.

The MSCI World Value index returned almost 34 per cent in 2016 alone, compared with 25.8 per cent for the mainstream MSCI world index. ETFs such as iShares Edge MSCI World Value Factor UCITS ETF (IWVL) is 17.21 per cent invested in financials stocks.

By contrast, quality – one of the newer factors – and low-volatility stocks tend to outperform in cautious markets and tend to include more expensive defensive stocks in sectors such as consumer staples. "Low volatility and quality stocks tend to be a bit more 'Steady Eddie' in nature and lag behind in sharply rising markets, but also hold it together better when markets are falling," says Mr Seager-Scott. "If you had perfect foresight of an imminent market crash I would avoid value and momentum factors and favour low volatility and quality stocks. Equally, if you had told me in March 2009 that there was about to be a sharp rally I would favour value and momentum stocks."

High and low risk factors

Momentum is potentially the most divisive factor among investors due to its methodology. "Momentum is a trend-following model and is much less clear on a fundamental basis as to why it works as a factor," says Mr Seager-Scott. "Some have suggested that it is more to do with behavioural elements of herding and lottery effects – the psychology of investors wanting to not miss out. Momentum indices tend to rally very hard when things are trending upwards and then fall very hard when markets turn. The same rules works on the way up and on the way down too," he says.

Mr Smith says: "The thing about momentum is that in a bull market environment you find it performs very well, but it is also susceptible to sharp reverses if asset classes fall out of favour. Typically a momentum strategy will have quite a bit of tail risk, so when you have a reversal in market fortunes you are likely to make bigger losses." 

And there is also a risk that momentum stocks are those with the highest, or most overvalued, share prices rather than the stocks with the best underlying fundamentals. Mr Smith says: "Momentum in the year to date has performed well, but that increase in share prices has not been driven by earnings improvements."

The MSCI World Momentum index trades on a price/earnings multiple of 21.58 compared with a price/earnings multiple of 20.80 for the MSCI World.

And the hidden trading costs that affect your returns are higher in these ETFs too, due to the higher levels of turnover in the portfolios. 

"The most high-octane factor to invest in is probably momentum, followed by value," says Mr Seager-Scott. "You can look at the volatility of the index to give you a sense of that. Momentum will also come with higher trading costs than some of the other factors."

How to put together a factor portfolio

When putting together a factor portfolio, there is no point buying all of them as you risk ending up with a more expensive version of the market.  

Instead, choose factors that work together, either by buying global factors that perform at different points of the cycle or combining regional factor ETFs with broader mainstream indices in order to mitigate your risk or take more tactical bets.

Mr Smith likes to use global minimum volatility, size and value factor ETFs. He says: "Value, size, minimum volatility and momentum are very well established factors. But I think minimum volatility and value will add the most value potentially to your portfolio because they behave in a way that is different to a market cap weighted index."

He recommends holding for the long term, as these factors add value over the long term but could go through short-term periods of underperformance. Global value ETFs include Vanguard Global Value factor UCITS ETF (VDVA) and iShares Edge MSCI World Value Factor (IWFV). Global minimum volatility ETFs have also performed strongly over the long term. Over 10 years the MSCI World Minimum Volatility index has delivered higher returns than the mainstream MSCI World index and over three years iShares MSCI World Minimum Volatility (MVOL) ETF has outperformed the MSCI World.

However Alan Miller, founder at SCM Direct prefers to use factor ETFs to make tactical tilts in particular areas of his portfolio. He says: “We take a regional approach to factor ETF investing because you often find there are times when stocks with particular characteristics might look the most appealing in terms of their underlying valuations in one area of the world but not another.”

He does not like paying for stocks with high prices relative to their fundamentals so likes value factor ETFs. He particularly uses these in the US at the moment, as a way of avoiding overvalued US stocks that have had a good run.

“I like to use value factor ETFs such as Powershare FTSE Rafi 1000 UCITS ETF (PRUS) [a fundamentally-weighted ETF index that uses value characteristics to weight stocks] because it reduces exposure to the expensive FAANG stocks [Facebook, Apple, Amazon, Netflix and Google],” he says. 

Currently Mr Seager-Scott says he would buy a global quality factor ETF - examples include db x-trackers MSCI World Quality Factor UCITS ETF (XDEQ) or iShares Edge MSCI World Quality Factor UCITS ETF (IWQU) "because I think markets have had a good run. If you do have concerns about the future and don’t think markets will rally aggressively from here that makes sense, he says.

"If you see the global economic outlook weakening it makes sense to be allocated towards companies with solid cash flows and reproducible earnings."

iShares Edge MSCI World Quality UCITS ETF tracks the MSCI World Sector Neutral Quality index, which is made up of large and mid-cap stocks across 23 developed countries and filters stocks by high return on equity, low earnings variability and low levels of debt.

He also likes using minimum volatility ETFs in emerging markets. "It makes sense to reduce exposure to the most volatile areas of emerging markets," he says.

He says: "Value and momentum can work well together because they perform at different points of the market cycle. You would historically not want to buy a value and growth ETF in the same region because you just end up with the market index."

The key when using factors is to understand the rules behind the index you are tracking. Not all factor ETFs are the same, even if they have similar names. For example, iShares and Vanguard's global momentum ETFs track different indices and so have very different compositions. Vanguard Global Momentum Factor ETF (VMOM) has more than 1,000 stocks included in the FTSE Developed All Cap Index and the Russell 3000 Index and so has more of a smaller-cap bias than iShares Edge MSCI World Momentum UCITS ETF (IWFM), which tracks the MSCI World Momentum index and tracks 354 stocks.

Think about your time frame

Factors perform very differently at different parts of the cycle. But that does not mean you should trade in and out of them frequently. Holding for the long term means you avoid the very likely risk of timing the market wrong and will also pay less in trading costs. But you should also be prepared to accept periods of underperformance.

However, some investors do use factors as tactical shorter-term tilts to a portfolio too, for example shifting towards US value stocks ahead of an interest rate rise. If you want to use this strategy make sure you have a solid core portfolio of broad global exposures as a core strategic allocation.

Mr Seager-Scott is a long-term investor and says: "Your likelihood of capturing the risk premia (return for the risk taken) increases over the long term, so investing over the long term is best and it does get harder to perform over the short term."

Mr Smith says: "If you take a tactical view you should really be investing with a time frame of at least six months to a year."

Some factors also work better for longer time periods than others too. Mr Smith says: “A factor like size you could hold forever and over multi-decade periods, size has added value over time particularly in the UK, where you’ve got a very concentrated top 10 holdings and size will add to your diversification.” However you are unlikely to want to hold on to momentum in a period when it has switched from positive to negative.

Factor performance compared to benchmark index 

Source: FE Analytics, as at 28.09.17

Performance of mentioned factor ETFs

Source: FE Analytics, as at 2.10.17