Factor investing became a hot topic in ETFs a couple of years ago, and the industry drumbeat has never been louder than it is now. In May, BlackRock chairman and chief executive officer Laurence Fink called it “the dominant theme of how we think about investing today” in a webinar on the topic. One of the firm’s most successful offerings, the iShares Edge MSCI Min Vol USA ETF (USMV), which has a factor bent, held over $12 billion in assets at the end of April and took in $4.7 billion in new money in the first four months of 2016 alone. A host of other ETF issuers, both large and small, have produced a plethora of factor-based ETFs in rapid-fire succession.

In contrast to fundamental valuation techniques, which look at company-specific characteristics such as earnings or cash flow, these strategies are based on “factors” that drive risk and return such as value, growth, momentum, size, quality and volatility. Studies by academics and analysts, which show that these factors and others have produced above-benchmark returns over the long term without increasing risk, are a big selling point for these ETFs. 

The concept is really nothing new. Graham and Dodd introduced value investing back in the 1930s, and in the early 1990s Fama and French demonstrated how the variability of returns among stock portfolios depends on their exposure to different company sizes, different industries and different company valuations. Many actively managed mutual funds incorporate factors into their strategies, and anyone that owns a value fund, growth fund or a fund with a similar “tilt” has factor exposure. Quantitatively driven ETFs that emphasize factors such as value, quality or growth have been around for well over a decade. 

But the new breed of factor ETFs introduced over the last couple of years often use more complex indexing strategies than their predecessors. They typically fall under the “smart beta” label and in some cases employ long-short investing or leverage. A growing number of “multifactor” ETFs offer diversification by incorporating several factors into one product. (See the box on the next page.) 

Product labels aside, issuers offering factor-based ETFs are trying to get investors to introduce factors into portfolios more methodically than they have in the past, and to make them a foundation for portfolio allocation rather than an afterthought.

Institutional investors such as pension funds have been receptive to these messages. According to a report from the Economist Intelligence Unit that examined responses from over 200 institutional investment professionals around the world, 62% of them felt factors could help achieve above-benchmark returns, and 61% saw them as a way to better understand what drives returns. Sixty-two percent increased their use of these strategies over the past three years, while only 3% decreased it. 

A Skeptical View

But even these institutional early adopters see limitations to the strategy. Nearly one-third of them believed factors are too complicated for consistent use in asset allocation. Respondents who did not use factors cited a lack of empirical evidence that they work and a lack of performance benchmarks.

Despite substantial academic literature supporting the merits of factor-based strategies, few studies address the real-world issues involved with implementing them. While the 30 to 40 basis point expense ratio many factor ETFs charge appears cheap next to actively managed mutual funds, they’re at least twice as high as the expense ratios of many more traditional market-cap-weighted passive exchange-traded products. Some of these ETFs are fairly new and thinly traded, which could increase trading costs. Leverage and short selling, used by some of the more complex ETFs in this category, introduce another level of risk.