What are Factor ETFs?

Factor ETFs enable investors to gain exposure to securities with common characteristics, which over the long term may deliver performance that differs from the broad market. There are many factors in markets, and they can be classified in ways to help investors understand how to best implement them as part of their broader portfolios.

Factor ETFs invest in a representative group of companies in a specific factor. Certain factors may perform better than others throughout different market cycles. For example, during a market contraction, investors might prefer securities exhibiting Low Volatility and Quality factor characteristics. Unlike an index ETF, which tracks the performance of the broad market, a factor ETF tracks the performance of a specific factor. Again, it does so by tracking an index. This is because virtually every major factor has multiple indexes that track each of their performances.

The most commonly used factors are “rewarded” factors,in that over time they have consistently delivered outperformance versus the broad market. Rewarded factors are typically understood to be the following:

• Size: Securities with smaller market capitalizations.
• Value: Securities with attractive valuations based on fundamental measures like book value to price, earnings to price and sales to price.
• Dividend Yield: Securities known to deliver attractive dividends.
• Low Volatility: Securities exhibiting lower volatility relative to the broader market.
• Quality: Securities with high-quality fundamentals and financials based on fundamentals like financial leverage.
• Momentum: Securities demonstrating consistent performance in one direction.

These rewarded factors can be further classified into offensive (size, value) and defensive (dividend yield, low volatility, quality). Momentum can be classified as a “trend” factor, which captures opportunities where there’s already considerable momentum.

These factors can be combined into pairs to enhance the final exposure, for example, by blending together high dividend and low volatility factors to enhance yield strategies and mitigate against “dividend traps” from occurring. Finally, investors can tactically or strategically allocate across multiple factors to form complete portfolios: these are called multi-factor strategies and can be accessed via ETFs too e.g., blending together quality, value and momentum.