Putting the X factors in your portfolio

Summary: Factor-based ETFs, also known as smart beta products, are on the rise in Australia.

Key take-out: Investors need to be aware they could be taking on unintended bets, although these can be reduced with the right investment approach.

Australia's exchange-traded funds sector is close to topping $40 billion, and there's a race on to capture more investor funds with a new breed of actively managed products designed to outperform the broader market.

The increasingly volatile trading climate, in which daily swings of 1 per cent or more are becoming increasingly commonplace, is creating the perfect storm for ETFs that don't just blindly invest across entire market indices.

Instead, these products are being structured in a way to reduce market volatility by only investing in stocks within an index that meet very specific investment criteria, such as those matching a predetermined level of sales, cash flow, book value or dividend payments. Companies that don't meet the criteria are automatically filtered out.

Other common factors being used are quality (financially healthy companies), value (stocks trading at a discount), momentum (stocks with upward price trends), and volatility (stocks with lower volatility characteristics).

By sorting the proverbial investment wheat from the chaff, investment managers are hoping investors will latch onto the concept and use these factor-based ETFs, otherwise known as smart beta products, as another tool within their portfolio arsenal.

Retail demand picks up

It's working too, with total assets within factor ETFs topping $US1 trillion globally at the end of 2017. Australian investors wanting the benefits of a passive index fund, with an actively managed hand on the rudder, are demanding more smart beta fund options.

Which is why, just in the past couple of weeks, both Vanguard and VanEck, two of the major players in the global ETFs space, have launched actively managed funds on the Australian Securities Exchange based around different factors.

Vanguard launched two funds, which are respectively seeking to achieve specific risk and return objectives through factor exposures towards global value and global minimum volatility.

“Factors are the DNA of an investment portfolio; the underlying characteristics that drive investment performance,” says Michael Roach, the Australian head of Vanguard's Quantitative Equity Group.

“Vanguard is taking a different approach to other factor fund offerings in the market – we are actively managing these portfolios, weighting shares according to their exposure to each factor whilst maintaining a broadly diversified investment portfolio.”

Meanwhile, VanEck launched a multifactor emerging markets fund which is based on the MSCI Emerging Markets Index, but which filters out stocks that don't meet its quality, value, momentum and size criteria.

“Emerging markets is currently one of the most attractive asset classes, with emerging markets stocks trading at a significant discount to developed markets,” says VanEck managing director Arian Neiron.

“Long-term trends too favour emerging markets. Emerging market nations account for almost 60 per cent of the world's population and account for an increasing proportion of global GDP, yet emerging market securities account for less than 10 per cent of all equity funds' holdings. Fund managers around the world are recognising the investment opportunity that these securities represent given their attractive prices and growth prospects.”

Expect more factor-based ETFs to hit the Australian product shelves over coming months, with other industry heavyweights such as BlackRock, State Street and BetaShares all wanting a slice of the lucrative smart beta pie.

The risks in factor investing

That's all well and good, but investors do need to be aware that factor investing – which is fundamentally designed to reduce risk – does carry inherent risks.

A study released last month by US-based firm Scientific Beta found that these risks can have a significant impact on portfolio performance.

“Although gaining explicit exposure to priced risk factors is expected to provide good long-term risk-adjusted performance, investing in these factors also exposes investors to several non-priced risks that could be important drivers of short-term risk performance,” said ERI Scientific Beta CEO Noel Amenc in a statement.

In other words, the very factors that some funds are using to reduce their risk could become threats instead of opportunities.

For example, depending on the factors chosen by an investment manager, investors could be unduly exposed to shorter-term risk factors including broad downward shifts in markets associated with macroeconomic, sector and geopolitical situations (think the US-China trade war and heightened tensions in the Middle East).

Paul Bouchey, chief investment officer at the Seattle-based funds management group Parametric, has been advising Australian superannuation funds around the use of factor-based ETF products.

There's strong interest, and he was recently in Sydney to meet with a number of senior investment managers here looking to use them in their portfolios. But he is also acutely aware of the potential risks.

“A lot of times these smart beta indexes or factor strategies come along with unintended bets. If you don't manage those unintended bets, they can really be a pitfall and a big risk,” Bouchey says.

He uses this example. “Let's say, you have a low volatility strategy. You say, ‘you know what, I like an equity strategy, but I want lower risk.' So, let's say you have one index that's a super simple strategy. It just sorts stocks by how volatile or risky they appear, and invests in half of the stocks that are the least risky.

“That strategy, one of the problems is, you might end up being in a period where low-risk stocks have very high valuations. So you happen to be investing in stocks that are very expensive relative to the average stock, the market averages. So, you're exposing yourself to a kind of unintended risk.”

The way around this, he says, is to build in constraints around the investment processes such as by imposing some sector diversification on the stock-selection process.

“We believe constraints are a critical part of the investment process, as they reduce the noise and amplify the signal for factor-based strategies, which can help you avoid the unintended pitfalls.”

The sensible approach

Diversification is key for every investor, and the same holds true for ETF products.

A diversified approach to ETFs is to not be overexposed just to one market, or to one sector, but to have a spread of holdings across different markets and sectors.

Factor-based products can help to reduce risk and volatility, but keep in mind that different factor variables can have the opposite effect over the short term if unforeseen events arise.

However, investment managers can reduce factor-based short-term risks and volatility through their stock selection criteria and processes.