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4 Reasons Institutions are Using Factor ETFs

Managing risk amidst volatility and goal-specific designs are driving growth

Concerned by the potential end of the current economic cycle and the specter of recession, possible tightening by the Fed, and geopolitical unrest, nearly 75% of portfolio managers and CIOs at U.S. institutions say that managing risk and return is their top forward-looking priority.1 The emphasis on risk management is revealed in a research study conducted by Greenwich Associates, and likely contributes to another of the report’s findings – a substantial increase in allocations to smart beta/factor-based ETFs.

Overall, institutional investors in the survey reported that a larger piece of their institution’s total allocation pie is being devoted to ETFs – nearly 25% of their total assets in 2018, compared to 18.5% just a year earlier. A main driver of that increased demand is the heightened interest in smart beta/factor-based ETFs, due in part to their risk management effectiveness. According to the report, one-third of institutions already invested in smart beta/factor-based ETFs plan to increase their commitment to that type of ETF, and of that cohort, 38% are planning on an increase of 10% or more in such allocations.

Tool of choice for portfolio construction

Widespread investor concern regarding volatility is clear in the report’s findings on which types of smart beta/factor-based ETFs are garnering the most institutional attention – minimum-volatility ETFs are among the most popular in the smart beta/factor sphere, with 56% of investors incorporating them into their portfolio to achieve what they feel is appropriate exposure to U.S. stocks. An example is the iShares Edge MSCI Min Vol USA ETF (USMV), which seeks to track an index composed of U.S. equities that, in aggregate, typically have lower volatility characteristics relevant to the broader U.S. market. Historically, USMV has declined less than the market during downturns.2 USMV aligns with the overwhelming finding in the report that 85% investors embrace equity ETFs in part because they are easy to use. In a single ETF, USMV helps meet these expectations by providing market exposure while seeking to reduce potential risk. 

Along with minimum volatility, more than 50% of institutional investors surveyed are using multi-factor ETFs as destination for allocations, and nearly half of investors are targeting single-factor ETFs, according to the report. Investors have been gradually warming toward various smart beta/factor-based ETFs, evidenced by the report’s finding that 83% of the institutions represented in survey response have “developed a robust understanding of how to implement these strategies in their portfolios.” A steady uptick in use of factor-based ETFs demonstrates this emerging confidence on the part of investors: In 2016, only 37% of investors in the annual survey reported that they invested in factor-based strategies through ETFs; in 2017, that figure to 44% of investors; in the 2018 study, 75% of investors say they either allocate to factor-based ETFs, or are considering it. 

As their comfort level with smart beta/factor-based ETFs has increased, investors in the study say they have developed views on specific factors that they want to implement into their portfolios. More than 50% of smart beta investors use multi-factor ETFs, such as the iShares Edge MSCI Multifactor USA ETF (LRGF). Composed of U.S. large- and mid-caps that have favorable exposure to target style factors subject to constraints, LRFG seeks to track an index that focuses on four proven drivers of return – financially healthy firms, inexpensive stocks, smaller companies, and trending stocks.3 The aim is to maximize exposures to factors that have historically outperformed the broad market while maintaining a similar level of market risk.

The report notes that nearly half of smart beta investors surveyed also leverage single-factor ETFs, such as the MSCI USA Momentum Factor ETF (MTUM), to provide exposure to U.S. large- and mid-caps exhibiting relatively higher momentum characteristics. MTUM helps manage exposure and risk within a stock allocation while accessing a specific factor that has historically driven a significant part of a company’s risk and return4.

Viewed holistically, the Greenwich Associates report provides four key takeaways regarding why institutional investors are increasingly engaged with smart beta/factor-based ETFs: They are easy to use, they potentially minimize risk, a single such ETF can incorporate multiple factors, and, conversely, if single-factor exposure is desired, that too is achievable with a single ETF.

Learn more about why institutional investors are using factor ETFs.

1 Source: Greenwich Associates 2018 U.S. Exchange-Traded Funds Study. Based on interviews with 181 institutional investors including investment managers, institutional funds, insurance companies, RIAs and other types of institutional investors, between 10/2018 and 12/2018. All data points shown in the article above were taken from the Greenwich Associates 2018 U.S. Exchange Traded Funds Study. BlackRock sponsored the study and is not affiliated with Greenwich Associates.

2 BlackRock, as of 6/30/2019. Based on the downside capture ratio of USMV vs the S&P 500  from 11/1/11 - 6/30/2019.

3 Source: MSCI

4 Source: N. Jegadeesh and S. Titman, “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.” Journal of Finance, 1993. 

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