Understanding factor-indexed ETFs

Factor-based exchange-traded funds are designed to get you returns that fall beyond those of traditional ETFs, which are based on a stock’s market capitalization.

Factor-based ETFs offer access to strategies that, in the past, were only available to portfolio managers.

These alternatively constructed ETFs offer focused exposures based on factors affecting equity risk and return: size, value, momentum and volatility.

As a strategy to exploit market anomalies in a rules-based, systematic way, they offer a sweet spot between active management and indices based on how well the market compensates investors for risk and for committing their money.

Factor ETFs use rules-based filters to create a ranked list of stocks from the available market. Selected stocks comprise an index constructed around a factor theme, such as value or volatility. To capture the small-cap effect, factor indexes can be equally weighted to inject a bias, or to tilt away from large-cap stocks.

A value-themed ETF will use value-oriented metrics to identify stocks and construct an index. For instance, it could equally weight five factors: price-to-earnings ratio, price-to-cash- flow ratio, price-to-book ratio, price to latest four quarters of sales, and three-month earning per share estimates.

Other factors could include:

• trailing return on equity;
• three-month earnings per share estimate revisions
• latest quarterly earnings surprises;
• price change from three months ago to current;
• price change over nine months;
• percentage price change from 12-month high.

Factors like these are important in identifying stocks’ value and momentum characteristics.

These types of ETF can also be used tactically to help rebalance Canadian portfolios that are too skewed toward financial services and natural resources. Alternative weighting methodologies naturally avoid the sector biases that creep into cap-weighted indices when so many large companies are concentrated in one industry. In Canada, investors can diversify their portfolios with factor-based ETFs that tilt away from the standard TSX Composite weights. This is an important strategy to consider when commodities markets are volatile (which impacts TSX Composite returns).

You’ll appreciate that factor-based ETFs are transparent and rules-based. The data is public, and show how these strategies have performed in the past. Most index providers make these histories available on their websites, along with all the known data on the stocks within each index.

Factor-based indices typically cost more than cap-weighted ones, because they’re more complicated and expensive to run. But factor-based ETFs should be judged less by traditional criteria, such as tracking error, cost and volume, and more upon their success in delivering the risk-adjusted return profile predicated by the particular factor they aim to get exposure to.

Barry Gordon is president and CEO of First Asset, a manager of ETFs, mutual funds, and closed-end funds. Rohit Mehta is a senior vice-president at First Asset.