The rise of factor investing: From academia to ETFs

Smart beta ETFs look to capture different factors such as value and momentum that can deliver superior risk-adjusted returns over the long term. 

The concept of factor investing has been around since the 1930s when Benjamin Graham and David Dodd highlighted the importance of finding companies that trade at a discount to what they are fundamentally worth in their seminal book, Security Analysis. 

Academic literature on factor investing was first documented in the 1970s, before Eugene Fama and Kenneth French published their three-factor model in the 1990s which highlighted market risk, size and value as three factors that can outperform. 

Smart beta ETFs: Capturing factors

Other factors that have been identified in academia are momentum, low volatility and quality. Here are definitions for the five most common factors: 

• Value: Companies that are fundamentally undervalued by the market 

• Momentum: Companies with strong past returns are seen as having positive momentum  

• Quality: Companies that have low debt, stable earnings growth and other financial quality metrics 

• Low volatility: Companies that exhibit less volatility, especially during periods of market stress 

• Size: Companies with smaller market caps 

Multi-factor ETFs

Academic literature has found these five factors, in particular, outperform market-cap-weighted indices over the business cycle.

As a result, asset managers created ETFs to track a basket of companies that exhibit characteristics of one of these five factors. They became known as smart beta ETFs.

Some smart beta ETFs combine factors to create multi-factor ETFs. Depending on the index provider, multi-factor indices encompass a combination of factors to provide diversification and risk-adjusted outperformance.

Smart beta ETFs are often considered the bridge between active and passive investing as they are rules-based but look to add alpha by systematically selecting stocks to target specific factors versus traditional market-cap-weighted ETFs.

Smart beta ETFs are designed to outperform traditional market-cap-weighted ETFs by using alternative weighting schemes based on factors that have been shown to generate excess returns over the long term.

Final word

However, critics of smart beta ETFs have argued they deliver similar returns to regular passive ETFs, and there is little extra reward for choosing a factor.  

Smart beta ETFs also tend to have higher fees than passive ETFs, however, they are less expensive than most active funds.