Exchange-traded funds can serve as tactical tools for those seeking to tilt their portfolio to certain factors.
By offering exposure to targeted indexes and providing intraday liquidity, exchange-traded funds can serve as tactical tools for those seeking to tilt their portfolio to certain factors. The purest factor ETFs are offered by QuantShares, with its suite of seven factor-based, marketneutral funds. But high fees and thin trading make them unsuitable for most investors. A wide variety of other ETFs offer outsized factor exposures. We list a few here and show their factor values for the first six months of 2012. These factor loadings are the slope coefficients from a regression of daily ETF returns on a four-factor model (market, size, value, and momentum). Data for the factors were obtained from Kenneth French’s website.
ETFs such as iShares Russell Microcap Index IWC and First Trust Dow Jones Select MicroCap Index FDM delve deep into micro-cap territory, but their high fees and trading costs make them less attractive than lower-cost and more-liquid small-cap ETFs such as iShares Russell 2000 IWM and Vanguard Small Cap ETF VB.
The Fama-French high-minus-low value factor is based on a single ratio, price/book, so it is no surprise that many financials ETFs screen as deep value based on that factor. A more robust way to define value would be to include other financial statement items such as cash flow and dividends. Morningstar takes the difference between five value factors and five growth factors to determine a fund’s investment style. Large- and mid-value ETFs with deep-value scores include Guggenheim S&P 500 Pure Value RPV, iShares High Dividend Equity HDV, and Vanguard Value ETF VTV.
Although ETFs such as QuantShares U.S. Market Neutral Momentum Fund MOM and PowerShares DWA Technical Leaders PDP track indexes built explicitly on momentum, the beauty of ETFs is that they give investors the ability to monitor and trade on what asset classes have good momentum. Cambria Global Tactical ETF GTAA uses a moving average indicator to overweight or underweight different segments of the market. A momentum-based, sector-rotation strategy could be honed to track the best-performing sectors. Through the first six months of 2012, the utility sector had strong momentum, as shown by the high factor loading for Utilities Select Sector SPDR XLU on momentum. A sector-rotation strategy would overweight utilities and underweight poor performing sectors.