- Factors are features of securities that can be used to explain risk and return.
- Investors can use factor ETFs to boost their returns, improve their investment performance, and reduce risk.
- Factor ETFs are not pure trackers; they stray from the market’s up and down movement to some extent.
- Because these ETFs are so new, it’s difficult to say how effective they are. The rationale, on the other hand, is good enough that a wise investment could pay dividends.
What is a value factor ETF, exactly?
The iShares MSCI USA Value Factor ETF aims to replicate the performance of an index made up of large- and mid-capitalization equities in the United States with value characteristics and lower valuations.
What exactly is a factor fund?
What are “factor based” funds, and how do they work? Factor-based funds are an active management strategy. They have the potential to meet specific risk and return objectives by “tilting” portfolios toward certain stock characteristics, such as recent momentum, greater quality, or lower stock prices, on purpose and openly.
Is factor investment similar to smart beta investing?
We could allocate to a combination of the stock market and a longshort multi-factor portfolio instead of designing an equity portfolio as smart beta by selecting stocks ranked by factors. ETFs or liquid alternative mutual funds could be used to create an alpha + beta strategy. The costs of beta ETFs, such as the S&P 500, are nearly nothing, and longshort multi-factor ETFs are priced well below 1%, resulting in total costs comparable to smart beta ETFs.
- To distinguish between beta and factor returns, a smart beta portfolio requires constant performance attribution analysis. It’s easy to tell if you’re getting outperformance with an alpha + beta portfolio.
- When it comes to portfolio creation, smart beta and factor investing are vastly different. Allocating to a longshort multi-factor portfolio produces returns that are more in accordance with the core scholarly research on factor investing.
- Stock market correlations in smart beta ETFs are more than 0.9. A longshort multi-factor portfolio, on the other hand, shows no link with beta. As a result, alpha could be used to supplement bonds in a well-balanced portfolio. This is an intriguing issue in a low-interest-rate situation. And the alpha’s portfolio weight might be customized to the risk preferences of the investor: the less risk averse the investor, the lower the beta exposure.
We built a number of alpha + beta portfolios that included exposure to the US stock market as well as a longshort multi-factor portfolio that included the Size, Value, and Momentum factors. Despite the fact that transaction costs are not included, the portfolios are rebalanced annually to reduce them.
The smart beta portfolio has the highest CAGR, followed by the market (beta) and other alpha + beta combinations. In a gradually increasing stock market, this illustrates the strength of compounding returns.
Investors would have had to continue with the smart beta portfolio, whatever the benefits of compounding were in hindsight. That would have been difficult in the face of maximum drawdowns of above 80%. The alpha + beta portfolios were spared from such precipitous drops. Investors aim to maximize their profits in theory, but in practice, we need a smooth ride to stay committed.
What is carry factor investment, and how does it work?
The carry factor is a related to the value factor, which is the propensity for relatively inexpensive assets to outperform relatively costly ones. It is the tendency for higher-yielding assets to provide larger returns than lower-yielding assets. Carry is defined as the return an investor receives (net of borrowing) assuming prices remain unchanged. The classic example is in currencies, where you go long the currencies of countries with the highest interest rates and short the currencies of countries with the lowest.
While currency carry has long been a well-known and effective strategy, the carry trade is a widespread phenomena that has proven profitable across asset classes. For example, Ralph Koijen, Tobias Moskowitz, Lasse Pedersen, and Evert Vrugt discovered the following in their 2015 study “Carry”:
While the term ‘carry’ is almost solely associated with currencies, it is a more general phenomena that may be applied to any asset.
So, what exactly is a factor strategy?
Factor investing is a strategy for selecting assets based on characteristics linked to greater returns. Macroeconomic factors and style factors are the two main categories of factors that have influenced stock, bond, and other asset returns. The former seeks to explain returns and risks within asset classes, whereas the latter aims to capture broad concerns across asset classes.
The rate of inflation, GDP growth, and the unemployment rate are all common macroeconomic parameters. Creditworthiness of a corporation, share liquidity, and stock price volatility are all microeconomic elements to consider. Growth versus value stocks, market capitalization, and industrial sector are all style considerations.
Is the size of an ETF important?
When comparing similar ETFs, the rule of thumb is that bigger is better. Larger ETFs can take advantage of economies of scale to reduce expenses and are less likely to be liquidated, which can negatively impact your returns. To be viable, ETFs must grow to a certain size.
What is a factor portfolio, and how does it work?
A factor portfolio is a diversified collection of equities with varied levels of risk exposure to factors such as inflation, interest rates, and oil prices. An investor can create a more diversified portfolio with a better probability of outperforming the market by combining the correct risk factors (also known as premiums). A portfolio is a collection of investment options.
The stocks in a factor portfolio are chosen so that they have a beta of 1.0 on one factor and a beta of 0 on all other factors. Countries, industries, and styles are used as explanatory variables, and stocks are assigned a 0 or 1 exposure.
A beta of one indicates that the price of the securities will move with the market. The security will be less volatile than the market if the beta is less than one. A beta of more than one indicates that the price of the investment will be more volatile than the market.
Univariate regressions that effectively treat the component in isolation produce simple factor portfolios.
Pure factor portfolios are the result of multivariate regressions that include all components at the same time.
“A well-diversified portfolio with a beta on one factor of 1.0 and a beta of zero on all other variables.”
Experts say the key is to choose elements with a lengthy track record of producing positive results and low (or even negative) correlations between them. Then, if one of the factors fails, there’s a strong likelihood that one of the others is keeping things in check.