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What are factors?
Hail Yang, Director, iShares Product & Markets, BlackRock Canada
To many, factors are the foundation of investing. They are broad, persistent drivers of returns across asset classes and their characteristics have been shown to deliver outperformance over longer timelines.
Investors look for new opportunities in the ETF market
And there’s five of them: value – companies that are trading relatively inexpensive to their fundamentals; size – smaller, more nimble companies; quality – companies with strong fundamentals; momentum – trending stocks or stocks on an upswing—
Investors increasingly looking to factor-based ETFs
And finally, minimum volatility – portfolios of securities that deliver strong downside protection while participating in a lot of upside as well.
Understanding how factor ETFs work
In today’s market environment, we are seeing increased investor demand for factor-based ETFs to deliver excess return or reduced risk in a differentiated way.
Why are factor strategies so relevant today?
The truth is factors have been relevant for a very long time. They’ve been around for decades. These are the same strategies that leading investors, active managers, institutional investors have been employing in their portfolios to seek outperformance and reduce risk. And the research that supports their existence has been around for even longer than decades. What’s changed is technology has changed.
So much in the same way that technology has changed the way we order a taxi or book travel—
Factors are the main driver of returns across asset classes
—Technology advances in computing power and increases of data availability allows us to harness and capture the power of factors in a more efficient way and deliver them at scale and at low cost in an ETF wrapper. You can think of today’s version of factor investing as transparent, rules-based active management delivered through a low-cost ETF wrapper.
How can advisors think about using factors within a portfolio?
Advisors need to understand how factors work to better capture their potential
So if you think about portfolio construction, you might be trying to achieve one of three outcomes. One is to try to be the market. Two would be to try and beat the market. And three would be to try to reduce risk. Area one, trying to be the market, is where you would typically use a traditional index ETF, like the S&P 500 exposure, for example.
RBC iShares offers Canadians a range of factor ETFs
Areas two and three, beat the market or seek reduced risk, have typically been an active proposition that you would normally look to an active manager to solve those two problems. This is an area where we’re seeing increasing interest in factor-based strategies and factor ETFs to deliver outperformance or reduced risk. So if you’re looking for outperformance, you would be looking at value, size, quality and momentum as the factors that you would seek. And if you’re seeking reduced risk, then minimum volatility would be the right factor for you.
How are you seeing advisors implement factor ETFs?
So we’re seeing three very common ways, and I’ll highlight them all. One is really as a complement to the existing active managers that they’re using in a portfolio.
Common methods advisors implement factor ETFs
- Complement actively managed holdings in their portfolio
- Factors increasingly used to express market views
- Factor strategies can help reduce portfolio concentration risk
So, much in the same way you might use and buy and hold a given active strategy to deliver outperformance or reduced risk,—
Understanding how factors work can help advisors capture their potential
—We’re seeing factor strategies used in the same way to either complement existing managers or in some cases, even replace underperforming active managers. Two, we’re seeing factors increasingly used to express a market view. So factors are cyclical by nature and some will perform better during certain parts of the economic cycle than others will. And so we’re seeing investors express a view on which one they think will perform better at a given point in time using factor rotation-like strategies. And finally, we’re seeing a lot of increasing interest – nowadays, through the pandemic as more and more people are working from home – we’ve seen a real run-up in a handful of technology-related names and that’s led to a lot of concentration risk inside of portfolios. I would divide the five factors up into two categories: cyclical versus defensive factors. In the cyclical camp, we have size and value, which would typically outperform in the early stages of a recovery. Momentum is also a cyclical factor which would typically outperform towards the later stages of an expansion. The defensive factors would be quality and minimum volatility, and these two factors typically outperform during a slowdown or contraction. Factor-based strategies in general are underweight that small basket of technology names, and so we’re seeing more interest in using factor-based ETFs to offset some of the concentration risk that exists in other parts of the portfolio. To put it another way, factor-based strategies and ETFs are seeking outperformance in ways different than owning that concentrated basket of technology-related names.