Many investors have used factors as a strategic tool to dial up client portfolios to meet investment objectives for years.
Factor ETFs have democratized factors, helping investors capture excess returns and manage risk. It’s an approach that leverages research, data, and technology to seek out historical return drivers in portfolios.
This strategy targets securities with specific characteristics such as value, quality, momentum, size, and minimum volatility. By dialling in to these well documented characteristics, which have a strong economic rationale, investors can use factor ETFs to build resilience in portfolios over time.
Factor investing is not new, but the rise of ETFs have helped revolutionise how they are accessed, giving investors outperformance potential and an ability to enter the market with less capital than other active investment options.
Understanding the different factor exposures can help advisers grapple with tactical allocations by linking factor styles to moments in the market cycle. For example, in macroeconomic scenarios with rising inflation and slowing growth, companies with higher quality could be worth considering as investment options.
In Australia, independent financial advisers like Andrew Saikal-Skea regularly turn to factor ETFs to dial up their portfolios.
Factor ETFs give investors access to higher potential expected returns offering a systematic approach, without having to go through each stock looking for a potential winner. They also have the potential to help advisers manage risk and reduce volatility within an investment portfolio.
“I moved to predominantly ETF portfolios, including factor-based ETFs a few years ago,” he tells Professional Planner.
“I favour the approach for clients who want less volatility in their portfolios. This is typically retirement-phase accounts as well as balanced and conservative investors.”
Understanding how factors work can ensure advisers capture good investment returns and reduce risk which can change the rules of the game.
“Our primary use is a quality filter to reduce volatility for our retirees and more conservative clients,” Saikal-Skea says.
“Aside from being able to provide a smoother return and income profile, quality filters can help clients that have been used to holding individual equities feel more comfortable moving to a diversified ETF approach.”
However, it’s important for advisers to understand investment costs and tax consequences.
“In the past, a lot of factor-based quality ETFs were quite expensive, so filtering for a simple high dividend ETF was a low-cost way to achieve a similar result,” he says.
“However, there are options now within the ETF market that apply a quality filter at a reasonable cost.”
He adds factor-based investing that leads to higher dividend yields can also result in taxable income at a time that a client has a high marginal rate.
“If this is at the expense of capital growth, where we have more control over when it’s released, the client can end up with lower net of tax returns,” Saikal-Skea says.
Meanwhile, most market cap index ETFs have lower turnover than a factor-based ETF, which can lead to more capital gains being passed to the investor at a sub-optimal time, and therefore worse net of tax outcomes.
“This is a concern for portfolios in the pension phase of superannuation or some other structures,” he says.
But there’s plenty of room for growth in the local market. It’s widely accepted that Australia’s market is less mature than the US when it comes to factor investing, however there are ways for local advisers to get ahead of the curve. Understanding how factors work can help advisers capture excess returns while managing volatility.
