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2021: The Year of Factor ETFs

In times of great volatility, a factor-based approach has the potential to shine.
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The stock market has been marked by extreme volatility in 2021. Inflation is significantly higher than previous projections and is expected to continue increasing throughout the year. To spur economic recovery, the Federal Reserve supplied a considerable amount of stimulus. However, that rocket fuel will soon be running out, as the Fed has signaled it will begin tapering bond purchases.

After a period of impressive market performance despite several difficult headwinds, many experts believe such significant growth will become difficult to maintain over both the short and long term.

The perception might exist among some investors that simply investing in U.S. large-cap stocks is an efficient approach to achieve growth, but it is not always the case. With the expectation that returns will be low in the near future, following a benchmark index like the S&P 500 may not produce sufficient returns in the short term. Furthermore, stock picking in an attempt to outperform the market often does not work.

Emerging Growth of the Factor ETF

Amid the current volatile market conditions, factor ETFs are emerging as popular investments. Factor ETF investing has grown throughout 2021, and, although future performance is not guaranteed, many expect to see even more success in coming years based on how factor ETFs have performed historically. 

Factor investing is rooted in the concept that every stock and company possesses certain characteristics, called factors, that can be tracked. Factor investing entails analyzing these traits, as well as current market conditions, in order to invest with an intentional bias toward or away from given factors.

The idea is that specific factors perform better in certain market conditions. If you can anticipate the conditions and invest in the factor with the most favorable growth potential, you might be able to outperform a given benchmark. Factor investing not only gives you the opportunity to generate increased returns, but it can also help de-risk your portfolio.

Four Main Factors

There are four main factors that investors follow:

  • Momentum: the likelihood a high-performing stock will continue to perform well
  • Volatility: the variance of returns for a stock, often associated with growth stocks, which swing up and down
  • Quality: the quality of a business model and the company’s competitive advantage
  • Value: the measurement of a stock’s market value compared with its intrinsic value

When it comes to factor ETFs, there are three types of funds. The first is single-factor investing, which is just what it sounds like: tracking one factor and investing in companies in the factor basket. Take, for example, a momentum ETF.

Blended factor funds are the second option. These invest in two or more factors and may seem like a good way to de-risk, but the returns can end up looking very similar to the benchmark. Blended factor investing does not allow for a single-factor opinion to shine through. For example, if the market is favoring momentum but not value and you’re invested in both, there's the potential for performance to be negated.

The third option, multifactor rotation, seeks to provide the best of both worlds. The S&P 500 has dictated that there are highs and lows for each main factor (high momentum and low momentum, high volatility and low volatility, etc.). Instead of simply cycling through the four main factors, the market cycles through these eight subfactors.

The S&P 500 has created investment baskets for each of the subfactors. Multifactor rotation observes the market on a routine basis to identify which two subfactors are performing the best and reallocates the fund to invest in the correlating investment baskets. Such an approach is arguably a strong way to achieve market outperformance because it allows for a very dynamic asset allocation approach, which is crucial in today’s fast-changing market.

One Step Further: Multifactor Rotation

Investing in a rules-based strategy fund, like a multifactor rotation ETF, can be particularly helpful during inflationary and volatile market environments. Monthly observation and the potential for rebalancing allow fund managers to keep an eye on the market and adapt if necessary. Investing via this type of strategy may offer an attractive opportunity to take advantage of fluid market conditions.

Historically, factor ETFs tend to work best when used in addition to traditional equity investments or benchmark ETFs. By investing in this way, a portfolio can follow the benchmark as well as the highest-performing factors, providing opportunity for both increased returns and risk balance, in case the benchmark takes a hit. Factor ETFs, like other ETFs, trade on the public market, making them easy to add to any portfolio. Investors can access them by asking their financial advisor or by going through their brokerage account. They should make sure to look at the prospectus carefully to understand the risks.

Factor ETFs are here to stay. They’ve helped investors navigate these volatile market environments and are poised to continue growing in popularity. With the future of the market so uncertain, factor ETFs appear to offer a good way for certain clients to potentially continue receiving strong returns.

 

Sean O'Hara is president of Pacer ETFs, distributed by Pacer Financial Inc.

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