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Digging Deeper on Factor ETFs

Last week I wrote about looking beyond the ultra-low-cost ETF that tracks a basic index. One logical next step might be sector-focused ETFs (like the SPDRs), but this requires predicting in advance which sectors will outperform the overall market, which is exceptionally hard to do consistently over time. Another sensible place to look is factor-based ETFs. Factor-based ETFs have the benefit of being based on empirical data demonstrating performance of stocks with certain factors vs. the overall market over historical periods. However, not all factor-based ETFs are created equal.

Let’s look at one type of factor-based ETF that has gained tremendous popularity over the last few years: Quality. Everyone likes the idea of owning “high quality” stocks, so this is an easy sell for financial advisors. Who is going to argue with high quality? But what does high quality mean? Well, it depends on which ETF manager you ask. For example, Blackrock’s iShares (the largest ETF issuer) USA Quality Factor ETF (QUAL) tracks an index that weights stocks based on five factors: return on equity, leverage, earnings variability, investment quality, and profitability. So now we have a five-factor model for one factor. And what does investment quality even mean? How is profitability measured? Even if you get comfortable with all this, then how are the five factors weighted in determining the stocks in the index? And how frequently are the weightings rebalanced? Other ETF issuers use between one and four factors to define quality, and none of them use the same factors.

This is starting to get complicated. How do you decide if one, or any, of these quality ETFs is a good investment? The idea of factor-based ETFs is to replace the subjective stock-picking of active management with the objective rules-following of passive indexing. But when you dig deeper, there is still subjectivity in choosing the factors, choosing the weightings, choosing the rebalancing schedule, etc.

I believe there is a better approach to factor-based investing. It involves focusing on the only three factors that have demonstrated material long-term outperformance vs. the overall stock market in practice (i.e., actual fund outperformance, not data mining and back-testing new strategies on historical data): size, value and profitability. It also involves active management, rather than passive indexing, but the active management is low-cost, focused on minimizing turnover and trading costs and maximizing expected return. It is quantitative, rather than subjective. It is available through Dimensional Fund Advisors in mutual fund form (with a 25+ year track record), and now in ETF form through Avantis Investors.

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