How To Implement Factor Investing With ETFs

In recent years, factor investing has become increasingly popular among investors as studies have shown that investing in stocks based on specific characteristics, or factors, has achieved superior returns over an extended period of time.

With the proliferation of factor ETFs, it is now easier than ever to implement factor investing for an investment portfolio. In this article, we will explore the basics of factor investing, the range of factors to select from, and the methods to evaluate the performance of factor ETFs.

What is factor investing?

Active investment managers base their investment decisions on thorough analysis of individual companies and their respective stocks. In contrast, factor investing prioritize identifying certain characteristics that historically outperform the broader market on a risk-adjusted basis.

The idea, originated from a research study in 1992, is that if you select a group of stocks based on these characteristics and construct a portfolio around it, the portfolio can theoretically outperform the market over the long term. As an intuitive yet data-driven investment approach, factor investing is widely adopted by investors, and can be easily implemented across a wide range of portfolios.

Many ETF providers now offer factor-based strategies that actively select stocks (and this has been expanding to additional asset classes as well). To invest in any specific factor, we can simply purchase the units of some of the most liquid ETFs.

Factors to select from

There are over 300 factors but we will consider the ones set out in the list below. All main ETF providers offer factor ETFs on the following:

Value. As one of the original factors, value is very well known and studied. It refers to buying undervalued stocks and selling overvalued stocks based on some metric. The original definition of value was based on the book-to-market ratio, an indicator of companies' financial health. However, modern methodologies might consider a variety of metrics to identify the value of the underlying stocks.
Dividend. This factor can be defined as the outperformance of those stocks paying high dividends compared with peers with lower dividends.
Low volatility. This factor assumes that the performance of stocks with low volatility is superior to their riskier counterparts over the long term.
Momentum. Another important, well known and studied factor is momentum. The rationale is to buy outperforming stocks and sell underperforming ones, as investors tend to select securities based on their past performance.
Quality. This expresses the tendency of high-quality stocks with typically more stable earnings, stronger balance sheets and higher margins to outperform low-quality stocks, over a long time horizon.

Factor Investing: Performance Analysis

How did factor ETFs perform in recent years? The following table illustrates the return of various factor ETFs between 2019 and 2022. Note that S&P 500 is also added to the table as a benchmark.

It is perhaps surprising to see that even for the same factor, different ETFs perform very differently. For example, between 2019 and 2022, State Street Value recorded a return of 57.99%, significantly outperforming iShares Value, which achieved a return of 40.44%.

We know that implementations can in practice differ, but by how much? And what is contributing to the difference in results achieved by different funds? There are a number of reasons:

Weighting schemes. Not every ETF provider assigns weights to the factors in the same way. Some may use more complex methodologies (for example, risk parity, portfolio optimization, etc) and others may use simple schemes.
Rebalancing period and logic. The rebalancing period and treatment can also make a difference. The frequency at which an ETF provider rebalances the fund may have an impact on its performance. There might also be special cases (e.g. when companies get into mergers or acquisitions or are delisted), and the rebalancing treatment might differ from one fund to another.
Selection. The methodology to select stocks can also be different. Some factors do not have standard selection criteria, and this might result in very different methodologies, scores and ranking systems to select stocks.
Long only or long-short? It is always possible to just invest in the entire universe by giving some overweight to some stocks, or construct a long-short portfolio by longing the outperforming group and shorting the underperforming group (based on any of the methodologies).

How to evaluate factor ETFs?

The evaluation of factor ETFs can only be meaningful if we can establish a framework to analyze their performance. We should not only analyze absolute returns, as this would be a poor and oversimplified method to make investment decision.

Generally speaking, there is no single performance indicator that would work alone. With a collection of indicators, we will get a sense of how ETFs differ with each other, as well as what we might prefer on the basis of risk aversion and risk tolerance. Basic indicators that investors typically consider include:

Annualized return. The return achieved during the year, keeping in mind compounding.
Annualized volatility. The volatility of the achieved return on an annual basis, which means how “different” the return might be on an annual basis compared with the average return.
Sharpe Ratio. The ratio between return and volatility, providing insight into the overall risk-reward profile of an investment. A higher Sharpe Ratio indicates a greater risk-adjusted return, indicating a more favorable balance between risk and reward..
Beta to S&P 500. This expresses the systemic risk of an investment, which means the expected percentage change for a 1% change in the index.
Expense ratio. This reflects how much a fund pays for its expenses, including portfolio management, marketing, custody etc.

The following table is a comparison of dividend ETFs offered by iShares (HDV), State Street (SDY) and Vanguard (VYM), based on the indicators above.

*Source: Yahoo Finance; author’s calculation*

Other considerations

Factor investing is a widely recognized concept in the financial industry that aims to decompose returns into identifiable factors. It is a relatively intuitive investment approach that has been supported by decades of research, and could be helpful to investors looking to boost their portfolio’s risk-adjusted performance over the long term.

However, factor investing is not without its pitfalls. First, there are plenty of factors, and uninformed investors might find it difficult to understand which factors to invest in. Second, the methodology behind each factor is sometimes unclear, and investors may be exposed to factors that are constructed in a way that is different from what they anticipated. Finally, factors can go through periods of underperformance, and it may require a long period of time before an investor can start seeing superior returns from factor investing.

Overall, we can conclude that factor investing is a useful strategy for enhancing the equity profile of a portfolio. However, rather than solely evaluating factor ETFs based on surface-level information, investors would benefit from dedicating time to comprehending the underlying factors within each fund. This diligent approach serves to mitigate potential risks and optimize the overall effectiveness of the strategy.