Explainer: What is a Factor-Based ETF? Sponsored by iShares
What is a factor-based ETF?
Asset managers often build funds that screen for companies that exhibit certain characteristics, or factors, so investors can set a strategy to potentially enhance returns, reduce risk or improve diversification.
Smart beta ETFs are one type of investment vehicle that investors can use to gain exposure to these factors. Because these funds seek to track indexes that are rules-based, rather than actively managed, they tend to carry lower fees.
So what are these factors and what do they do?
Five common factors are value, size, quality, momentum and minimum volatility, each a separate vehicle to take you on a particular path.
The first four factors are about potential outperformance and portfolio diversification. Value ETFs track indexes that screen for stocks with lower prices, relative to fundamentals, while size ETFs track indexes focused on smaller companies that may have more room to grow.
Quality ETFs follow indexes that check under the hood for companies that are financially sound.
And momentum ETFs track indexes that screen for stocks that are trending up.
Some factor ETFs, however, focus on reducing risk.
Minimum volatility factor ETFs follow indexes that select companies that are historically more stable, trading a bit of upside for the potential of reduced risk on the downside. These funds are designed to help investors continue to make rational decisions by reducing some of the extreme swings that can lead to emotional reactions.
Now, any of these factors can be used on their own in what’s called a single-factor fund, where the index construction favors stocks selected for an individual attribute. They can even be used in conjunction with each other in allocating a portfolio.
Some financial advisors, however, may prefer to include multiple factors within a single investment for their client. That is where multi-factor ETFs come in.
A multi-factor fund selects stocks with multiple factor characteristics, such as quality, value, momentum or size. Investors can use these funds to access multiple factors within an underlying asset class.
For instance, investors may use multi-factor funds to capture exposure to typical portfolio building blocks like domestic, international or emerging markets stocks, while seeking outperformance over a traditional market-cap weighted index.
So, if your client is simply looking to track the market through all of its ups and downs, traditional market-cap index funds may be the answer. Some clients, however, may want the potential for less risk, or the opportunity to outperform a common market benchmark. Factor-based smart beta funds offer the opportunity to meet these alternative objectives.
There can be no assurance that performance will be enhanced or risk will be reduced for funds that seek to provide exposure to certain quantitative investment characteristics ("factors"). Exposure to such investment factors may detract from performance in some market environments, perhaps for extended periods. In such circumstances, a fund may seek to maintain exposure to the targeted investment factors and not adjust to target different factors, which could result in losses. Minimum Volatility ETFs may experience more than minimum volatility as there is no guarantee that the underlying index's strategy of seeking to lower volatility will be successful.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
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