Factor funds - the even better ETF

Is smart beta worth a look?

Factor funds - the even better ETF

Ever since ETFs came on the scene, people have been attracted to them as a cost-effective means to access markets. But traditional ETFs are very generic. Because they are normally based on market-weighted indexes, larger companies account for a greater percentage of the overall return than smaller ones.

But is bigger always better? Not necessarily.

Enter factor investing, also known as smart beta or alternative beta. The theory behind factor investing is that other characteristics beside size may make better selection criteria for stocks. These are called factors. Popular factors include value (low stock price compared to what the company is worth), low volatility (steady historical stock price), high yield (company regularly pays dividends), quality (business model with predictable cash flows), and so on.

Factor-based ETFs have become very popular lately. Over the past five years we’ve seen cumulative annual growth rates of more than 30% in the asset class. Of these, dividend ETFs seem by far the most well liked. At the end of June there were 140 billion US dollars invested in them. Value-oriented ETFs, with 63.5 billion, and growth-oriented ones, at 46.5 billion, are popular as well.

What’s the appeal? As we point out elsewhere, evidence is accumulating that factor theory is borne out by reality. Factor-oriented ETFs have indeed been outperforming.

We think that makes them worth a look.