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By Paul Justice, CFA | 06-30-2011 11:34 AM

Dissecting Factor Investing

Axioma's Chris Canova and Russell's Ed Rosenberg discuss how to gain exposure to factors like momentum, size, and volatility using ETFs.

Paul Justice: Dissecting factor investing. Hi there. I am Paul Justice with Morningstar, director of exchange-traded fund research. Russell Investments recently launched 10 different ETFs that are based on investment factors. Today, to join me in this discussion, I have Ed Rosenberg of Russell Investments and Chris Canova from Axioma, and you two partnered up to bring forward 10 different factor strategies in the Russell ETF platform. If you wouldn't mind, talk about really what you're looking at when we say factor investing; this is well beyond just basic indexing.

Chris Canova: Thanks, Paul. I think when you think about factors, it's important to think of them in the context of an investment theme and portfolio themes. There's lots of different investment vehicles out there that allow you to gain exposure to certain types of stocks. Factors really allow you to take an exposure to various categories, for example, within equities. So, when we talk about the Russell- Axioma factor indexes, momentum, beta, size, and volatility, and when we look at the indexes that have originally been launched--for example, if I am an investor and I want to take an exposure or directional bet on a low-volatility portfolio--the factor-based indexes essentially allow me to do that.

Another important aspect of the factor-based indexes is remaining pure to other factors that might exist in the investment opportunity set. So, if I am a long-term investor and I want to take some exposure to momentum, I might be able to find a particular set of securities that give me exposure to momentum; however, there can be other baggage that comes along with an exposure to momentum stocks. Is there growth in there? Is there volatility in there? The methodology really allows investors to ensure that when they take an exposure or make an investment in a particular ETF, they are neutralized to other important factors in the market, so there's a purity of the factor-based ETFs that exists.

Justice: Now Ed, you're on the product side. It seems that these are pretty finely tuned instruments maybe for someone who has a very refined investment thesis around what factors that they are seeking. Could you talk about how these strategies are implemented, what's actually underlying the ETF, and how much turnover these might generate?

Ed Rosenberg: So, the first thing is, it's individual securities underlying the ETFs. There are no derivatives or anything else in there, but individual securities. The second thing is how people would use these. The idea behind these is to enhance or mitigate certain risks in the portfolio that may come up when you do certain types of investing. You may enter certain pool of stocks that may cause certain risks in the portfolio that you don't see. An example of something you would see or you are used to is that maybe you take a value bias or a growth bias, but something you don't see might be a momentum or volatility.

So, adding these to your portfolio could help you enhance the risk that you want to add to it or mitigate a risk that you want to take away. And as Chris said, by doing this with ours, we do offer a more pure portfolio with the idea of exposing the risk that you want by mitigating the other risks in the portfolio. The one thing that does lead to is potential turnover. So, the funds do rebalance monthly, which can cause a slightly higher percentage of turnover than a normal index investor might be used to.

Justice: Great. So, these are generally low-cost ways for someone who is probably familiar with people like Fama, French, and Carhart, and really want to apply those methodologies in a very targeted way to their portfolio?

Rosenberg: Absolutely. Think of how you would do this today before these portfolios came out. If I wanted to enhance or mitigate a risk, I might have to sell a security that I normally wouldn't want to sell to alleviate momentum. I might have to go the options route or sell a security short. There really was no clean way to put this into a portfolio, whether I wanted to add momentum or take it away.

Now, I have the ability to do it with an ETF that is based on individual securities as opposed to using some other strategy in the portfolio, such as options or futures or even selling the securities that I believe you have the most growth potential.

Justice: All right. Well I look forward to reviewing some of these strategies with you and hopefully sharing those with our viewers. Thank you for joining me.

Rosenberg: Thank you.

Canova: Thank you.

 

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