New Factor-Based Strategies Make ETFs Less Passive
Exchange-traded funds increasingly seek to rebalance their portfolios without bastardizing the concept of passive investing.
Tomorrow, on October 25, State Street Global Advisors of Boston will be launching its first factor-based “tilt” funds on the New York Stock Exchange’s Arca platform as part of its SPDR product line.
In doing so, SSgA is joining a growing trend towards launching ETFs that are not completely passive, but not actively managed, either. That trend already includes FlexShares and its line of “tilt index” funds, and Invesco PowerShares and its ETFs based on the DWA Technical Leaders index, as well as others.
Most ETFs are still designed to track an index passively at a low cost.
But the market can support only so many ETFs that simply copy an index, and with actively managed ETFs still problematic, there is a growing category in between: ETFs that use “factor-based strategies” to reweight indexes in favor of factors other than market capitalization. Such ETFs are still in the passively managed camp because once they establish their rules for reweighting, they have to follow those rules, but they’re not plain-vanilla passive, either.
“They’re active in nature but passive in practice,” says Paul Baiocchi, an ETF analyst at San Francisco–based IndexUniverse.
The two new SPDR ETFs – SPDR S&P 1500 Value Tilt ETF (VLU) and the SPDR S&P 1500 Momentum Tilt ETF (MMTM) – apply “alternative weighting” methodologies, according to their SEC filings. The first will overweight S&P 1500 stocks with relatively low valuations while underweighting those with relatively high valuations, while the second will apply the same sort of overweighting/underweighting methodology in terms of momentum.
“A lot of the new index funds deviate away from market cap and try to implement strategies that add performance over the market cap performance,” says Samuel Lee, the editor of Chicago-based Morningstar’s newsletter, ETFInvestor. “The most common type of non-market-weighted strategy is the value strategy, where stocks are cheap by some sort of fundamental accounting measure — price-to-earnings, price-to-book or price-to-cash-flow,” he says. But there are a number of factors that can be used in reweighting indexes, for instance, “company size is well accepted as a factor,” he says.
Northern Trust of Chicago was the first to launch a “tilt index” fund, a year ago in September, and it just added two new “tilt index” ETFs this October 1. In its product literature, FlexShares describes its tilt funds as “applying a nuanced ‘tilt’ methodology” that weights its portfolios more towards small-cap and value stocks. The funds still include large-cap and growth stocks, but “seek to counterbalance the inherent bias toward large-growth companies embedded in market-weighted strategies,” the firm says.
The first FlexShares “tilt index” ETF was the FlexShares Morningstar U.S. Market Factor Tilt Index Fund (TILT). As of October 18 it had $141.6 million in assets, with a one-year gain in net asset value of 30.33 percent as of September 30. This October 1, the firm launched two more tilt index funds — one, on the developed markets ex-U.S. (TLTD) and seeded with $10 million in start-up capital, and the other, on the emerging markets (TLTE), seeded with $5 million, “completing the continuum” in terms of offering “coverage of the globe,” says Shundrawn Thomas, the head of Northern Trust’s exchange-traded funds group. As to why the funds tilt the way they do, he says that “historically, the market has paid you a premium for investing in small-cap and value stocks,” and the firm believes the market is now moving towards the “next evolution” in ETF products, with “more targeted, more sophisticated investment strategies.”
The tilt ETFs may be more complex, but they are still “very competitive” in terms of their net expense ratios, both in terms of other ETFs and also in comparison to actively managed mutual funds, Thomas notes, with the U.S. ETF at 27 basis points; the developed markets, at 42 basis points; and the emerging markets, at 65 basis points.
There’s another key difference. Most indexes based on market capitalization are rebalanced just once a year, but the indexes that are used for factor-based ETFs are usually rebalanced more frequently.
For example, Invesco PowerShares of Wheaton, Illinois, offers four ETFs based on the DWA Technical Leaders index created by Dorsey Wright & Associates of Richmond, Virginia. That index measures the relative strength or momentum in stocks to pick out the top 100 stocks in three categories — large- and midcap U.S. stocks (PDP), developed markets ex-U.S. (PIZ), and emerging markets (PIE) — and the top 200 small-cap stocks (DWAS). All four are reweighted quarterly.
“We could have chosen weekly or monthly, but quarterly worked out the best for us in our test,” says Tommy Dorsey, a principal in the firm, emphasizing that the selection of the “leaders” is all machine-driven, “with no human intervention. What’s taken out of the equation is human emotion. It’s all rules-activated.” Dorsey believes that ETFs “should stop short of being active and trying to compete with mutual funds,” because once they become actively managed, “you have that emotion, and that’s where the ETF has become bastardized,” he says.
Not all of the factor-based ETFs to hit the market have succeeded. The most notorious failure is the ETFs launched by Russell Investments of Seattle — based on factors such as low and high volatility, and low and high beta — which were killed off last August.
But “people are experimenting and trying a lot of different things,” says Mike Moody, a senior portfolio manager at Dorsey Wright Money Management, the Pasadena, California–based asset management arm of the Richmond firm. “In just the last few years, there’s been an explosion with both academics and practitioners discussing how factor-based returns combine in a portfolio,” he says. “The dominant method for a long time has been characterizing equity through style boxes — small cap, large cap — and they’re all pretty highly correlated, but if you take that universe and you add in factors like low volatility and relative strength, they don’t have the same correlation,” he says.
Baiocchi of IndexUniverse agrees “there’s been a noticeable uptick in these factor-based strategies over the last two years.” He also says “we haven’t seen a tremendous amount of outperformance, but to be fair, many factor-based strategies are very new, and they need five years, which is sort of the traditional window to be able to use performance history.”
But Baiocchi doesn’t doubt that factor-based ETFs are “a growing phenomenon,” and he says they will continue to “fill the middle road between passive and active ETFs.”
This article has been updated to include the discussion of new funds introduced by NYSE ARCA.