The last decade has been quite fruitful for investors as we experienced one of the greatest bull markets in beta or passive investing. To put it into perspective, a $10,000 investment in an S&P 500 Index-tracking product at the end of March 2009 would have grown to $65,000 by the end of May 2021. While the multi-decade decline of interest rates helped contribute to the success of passive investing, current market conditions might favour a fundamental approach using factor investing – commonly referred to as smart beta.
Evaluating Factor ETFs
Looking at investing through a factor lens can help dissect and construct stronger portfolios, but it’s important to remember that not all factor indexes or strategies are created equally. Given the recent resurgence in value strategies (and the money that has followed suit), I felt it would be prudent to cover some best practices and what we coin as the 3 P’s for evaluating factor ETF strategies.
It’s quite common to have two strategies that are classified the same but have very different investment processes. For example, you may have two strategies that focus on the dividend factor but end up looking completely different from a holdings and performance perspective. This is because there is no uniform way to quantify a factor. One strategy may focus on a history of dividend payments (backward looking), while another might focus on a company’s ability to grow its dividend over time. This highlights the importance of looking under the hood to ensure the strategy’s objective is consistent with your views.
When examining a strategy, work with your advisor or broker to look at the portfolio’s holdings, investment process or index methodology, and use third-party sites that quantify factor exposure. This will help ensure that you are capturing the right factor benefits without any style drift.
As noted above, you can have two strategies focused on the same factor with entirely different performance results. When evaluating factor strategies, it’s important to look at how the strategy performed in different periods and regimes.
When evaluating performance – if it’s real-world performance – ask yourself if the performance was internally consistent and does it deliver what was intended by the portfolio’s design. With a new product that lacks a track record, you can look at the performance back test, but you or your advisor will want to do some additional due diligence and look closely at the underlying methodology.
With price, you want to look at the total cost of ownership. This goes beyond just the management fee and involves looking at other costs such as the bid-ask spread and premium/discount to the net asset value (NAV). It‘s important to consider whether the additional cost is justified. For example, a strategy that targets the size factor tends to focus on smaller-cap companies, which may have a wider bid-ask spread. As compensation, these companies typically offer a size premium with the potential for higher alpha.
Putting it all together
By having a framework and looking at process, performance and price, you can have a better and smarter way of evaluating which factor funds work best for you. And of course, it’s always best to focus on how the product fits into your long-term portfolio objective.
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