The growth of factor-based investing

The steady migration of investor assets out of actively managed mutual funds and into passively managed exchange-traded funds is fueling the growth of factor-based investing, an old idea that has taken on new appeal for financial advisers and retail investors.

Much of the growth in factor-based products has occurred over the past few years. According to a recent report by Morningstar Inc., almost $800 billion is now invested in nearly 1,500 factor-based exchange-traded products, up from approximately $700 billion a year ago and $600 billion two years ago.

Along with that growth in factor-based ETFs has come an increased use of factor analysis by financial advisers.

Factor-based investing looks at a number of characteristics that are associated with either higher returns or lower risk, such as momentum, value or size. For advisers, the appeal of factor analysis is the ability it provides to make investment decisions based on those factors, which are regarded as a more precise tool for portfolio construction and risk management.

“It’s been a journey for me away from active managers and toward factor funds, but I’m now analyzing client portfolios based on factor exposures,” said Eric Walters, president of Silvercrest Wealth Planning.

‘More Technical’

“Active managers are trying to guess the market,” Mr. Walters said. “With factor investing, I decide which factors are important to my clients and I do the research looking for funds where those factors are most robust. It’s more technical than just picking active managers.”

James Gambaccini, managing partner at Acorn Financial, said factor investing has become his competitive edge.

“We determine what factors we need in a client’s portfolio and then screen the entire fund universe for those factors,” Mr. Gabaccini said. “The real advantage is on the risk side, because when markets go down, our portfolios don’t seem to go down as much.”

For example, an adviser might use factor analysis to identify less expensive versions of a client’s current portfolio. Or an adviser with a client in or near retirement who is looking to reduce investment risk without completely getting out of the market might look at low-volatility factor strategies that could be used in place of funds with more aggressive growth attributes.

Mike Buonassisi, vice president and portfolio manager at Altium Wealth, cites the risk-management benefits of factor-based investing.

“The way we design portfolios for clients is with core strategic asset allocation models; then we optimize factor exposure based on where we are in the business cycle,” he said. “From a risk-management standpoint, it worked great last year.”

Mr. Buonassisi also believes the quantitative nature of factor investing can help advisers keep clients calm in times of market turbulence.

“One of the bigger things is it keeps investor biases out of the portfolio, because by having the correct factors from a risk-management standpoint, it keeps clients in the market,” he said. “If we get risk right, the returns will take care of themselves over a long period of time, and we know that staying in the market is the important part.”

Factor strategies, which are packaged mostly in ETF form, are often promoted as a kind of active-passive hybrid that checks all the right boxes in terms of low fees, liquidity and transparency without being a pure index fund that just moves in stride with the broad markets.

“A big part of the appeal is that factor investing is not expensive and underperforming active management, and it’s not just an index,” said Dana D’Auria, managing director at Symmetry Partners, which builds factor-based model portfolios for advisers.

Ms. D’Auria said the first challenge in using factors to invest is getting advisers on board with a concept that is not always intuitive.

‘The source of returns’

“To understand factor investing, you have to understand that factors are the source of returns whether you know it or not,” she said. “Our findings are that a lot of the advisers don’t know what to ask for in the factor space, but they understand academic research has uncovered this, and that it can probably benefit clients.”

Factor research has been employed for decades by institutional investors. But evolving technology is making it easier to measure investment characteristics such as growth, value and momentum for any security, fund or client portfolio.

For a lot of advisers, the move toward factor investing begins with a shift away from expensive active management and toward low-cost indexed strategies. But most indexed funds, especially those with the lowest fees, are providing some form of market-capitalization-weighted exposure to an index, which essentially means buying more of the most expensive underlying securities.

The cap-weighted conundrum has been addressed with gusto since the financial crisis with various forms of smart-beta strategies that re-weight broad market indexes based on criteria other than a stock’s market cap. Factor-based investing goes a step beyond smart beta because it not only measures the sources of performance and risk in existing portfolios, it allows for the development of ETFs that concentrate and combine those attributes to allow for more targeted asset allocation.

“Factors like value versus growth and large cap versus small cap have been a big driver of investment returns for a long time, but the new technology is now allowing investors to better understand how factors work in their portfolios,” said Paul Kim, head of ETF strategy at

Principal Financial Group.Factor analysis can be applied to any fund, whether it is a factor-focused strategy, an actively managed fund or an index fund. The idea is to illustrate what factors are dominating a strategy and therefore driving risk and returns. Advances in this space have resulted in a flood of factor analysis tools that help advisers better understand factor investing by illustrating which among about a half-dozen attributes dominate various strategies.

BlackRock’s iShares, for example, has The Factor Box, which weighs the value, size, momentum, quality, dividend yield and volatility attributes of a fund against a benchmark.

“Factors are fundamental investment tenets that have long been used, but what’s new, with improvements in data and technology, is that we can now access these attributes at a far lower cost,” said Holly Framsted, U.S. head of smart beta at BlackRock.

‘Factor DNA’

At Invesco, the Factor eXposure Tool measures factor exposures of any fund, producing a basic “factor DNA.” Nick Kalivas, senior equity ETF strategist at Invesco, said advisers are using factor strategies to better tailor client portfolios.

“A lot of advisers are looking to build portfolios that meet the specific needs of their clients,” he said. “Maybe they want to get more aggressive or less aggressive, or they want lower volatility or dividends for quality. A lot of advisers are looking to single factors to finish off or tweak a portfolio.”

The Vanguard Group, which has a factor analysis tool designed specifically for financial advisers, goes the extra mile by calculating factor exposures in a fund or portfolio and then listing lower-cost alternatives that have the same factor levels.

“This is the next silver bullet in portfolio construction,” said Evan Wolf, head of ETF portfolio analytics in Vanguard’s Financial Advisor Services division. “We believe factors can be a great part of the tool kit and can help advisers to continue to build better portfolios.”

Like most factor-investing wonks, Mr. Wolf considers it an extension of the traditional nine style boxes popularized by Morningstar, which highlight growth compared to value and large compared to small companies. Growth, value and size are among the common factors used in factor investing, but the list usually also includes attributes such as dividend yield, momentum and volatility.

“In a basic nine box, it shows something like a fund’s strong value tilt, but not a deeper factor analysis,” Mr. Wolf said.

That deeper factor analysis, now readily available for free at a host of asset managers, is something that can be easily applied at the asset allocation level for clients.

Where factor funds are most like actively managed funds is with regard to the underlying characteristics of the factors. While academics have identified hundreds of potential factors, the asset management universe has homed in on about six. But, as the proliferation of factor funds suggests, the secret sauce is in how each quant strategy defines the factors.

“There are lots of different ways to define a factor, which is why we will continue to see new products,” said Jonathan Belanger, chief technology officer at AlphaCore Wealth Advisory. “When we talk about value, I might be talking about a price-to-book ratio and you might be talking about cyclically adjusted price-to-earnings.”

With that in mind, even if advisers know what attributes they’re looking for, factor-based investing can become as challenging as picking the right active manager.

“The due diligence means looking through to what guides the process, and you should be applying the same level of due diligence you would apply to an active manager,” said Ben Johnson, analyst at Morningstar.

While there is no disputing factors as sources of risk and return, the advisory space is still finding its footing when it comes to their application in portfolios.

“Three years ago, we were explaining to advisers what a screen for quality meant, and now they’re starting to think more creatively about how they can be used in a client’s portfolio,” Ms. Framsted said. “Most advisers now understand that factors are already part of what they’re buying.”