Factor-based ETFs could help you diversify

Index investing has never been seen as very glamorous - many think of it as being a dreary way to guarantee you will always underperform the index.

Factor-based ETFs could help you diversify

The evidence suggests that it is still a better approach than active investing, which is merely a more exciting and expensive way to end up in the same place!  All the same, there are still many who prefer to travel in hope, which probably explains why active investing is still more popular than passive.

‘Smart-beta’ ETFs offer a middle ground where investors have a possibility of beating the underlying index by picking only certain stocks within it, with the comfort of set index methodology. These may well add back a little of the excitement, especially when they work well and beat the index, but the jury is still out as to whether they are more useful for helping ETF providers nudge up their fee margins than for improving performance.

Investing only in liquid, investible indices can certainly bring unexpected outcomes though. Major indices tend to move in similar ways; if the S&P 500 sneezes, all the other main markets also catch a cold. This makes a case for using differently-constituted indices to help reduce correlation and limit portfolio volatility, so over the past few months my colleagues at Charles Stanley Pan Asset have spent a lot of time researching them. An interesting recent development in this area has been a set of factor-based ETFs from Source ETF which set out to enhance and diversify returns without excessive risk. A ‘factor’ is a measure such as value or momentum and some of these systematic factors are well-known sources of outperformance.

Its proponents would say that factor investing is nothing new and is already widely used by active managers.  There are various supporting academic studies, such as Carhart’s 1997 study showing that equity mutual fund returns can be almost completely explained by common factors, something which may already be intuitive to most seasoned investors. The challenge, though, is to know which factors are going to perform well at any given time as, like any other measure, outcomes for each factor vary year by year.

If you plan to try this approach it makes sense to diversify across a range of factors ensuring that they are not highly correlated. Without care, you might just be concentrating your risks; for example, if you just move to investing in small capitalisation shares, or indices, across a range of markets you may find that small caps around the work underperform at the same time.

I found this approach interesting purely because, unlike some smart beta products I have looked at, there is no analysis at the underlying company level. Taking companies to pieces and constructing alternative indices from the results generated sounds uncomfortably like a stock-picking approach to a passive investor like me. The factor approach is slightly different. It is company-agnostic, simply analysing the factors exhibited. It acknowledges that the contribution of one single factor cannot be predicted over time so it blends some of the more important factors. Being able to address the distortions which go with market cap-weighting is an attractive solution, in spite of the relatively high cost of the ETF.

In my view, reducing correlation between holdings and bringing down volatility are all good reasons for introducing this sort of product into a portfolio, so I will still be happy even if its take on the MSCI World does no more than match the underlying index performance over time.  Even better will be the day when we can buy these useful diversifiers at the same cost as plain vanilla trackers.

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Categories: Analysis

About Author

Christopher Aldous

Christopher Aldous is managing director of Charles Stanley Pan Asset