How to Pick ETFs with Factors
Did a community event with Finimize yesterday and thought some of the discussion could be useful for you here. The topic was about ETFs and specifically how to apply Factors to select ETFs.
With more than 2,000 ETFs listed in the US alone, the problem today is paradox by choice, and investors have the fear of choosing the wrong ETF.
You can select an ETF based on geography, asset class, sector, theme, Factors and more. The focus here is Factors.
What are Factors? Factors came from academia research whereby the professors used data to prove (or disprove) certain investment styles of metrics are able to deliver higher returns. It is quantitative and data-driven.
For example, does PE ratio work? They would test this metric against all the stocks. It is considered a Factor if it is able to show higher returns. But to be clear, Factors are not metrics. You can call it a style. More correctly, PE ratio is typically used in value investing and hence, Value is the Factor here. And the Value Factor can be expressed by other metrics besides PE ratio.
There are many Factors but the key ones are Value, Quality, Momentum, Size and Minimum Volatility.
I was asked which Factor would outperform in 2022 and my answer was Value.
There were two reasons. First, Value and Growth (can be represented by the Quality Factor) are opposite sides of the same coin - when Value does well, Growth doesn't and vice versa. Growth has been outperforming well in the past few years while value lagged.
That was because Growth benefit in a low interest rate and low inflationary environment - the future value of Growth stocks are discounted at a smaller amount to today's dollars. But now the interest rate regime has changed. Higher rates would now discount future value in larger amounts. Value doesn't have this discounting problem as the value already exist today.
The second reason is inflation. Many of the commodity-related stocks are Value stocks, for example, the oil and gas stocks. And you can see Buffett loading them up in recent months because they are still cheap. Hence, Value stocks can have a higher chance to prosper if inflation problem remains and Vanguard Value ETF (VTV) $价值股ETF-Vanguard (VTV.US)$ is one of the most popular Value ETFs.
Should investors diversify by Factors too? Yes, this is because no one Factor can outperform all the time and it is not possible to guess which Factor is going to outperform next. Putting counteracting Factors together (such as Value and Quality) would make sense. The higher non-correlation the better. This is where one can do rebalancing regularly to capture the capital gains - Partially sell the Factor that has performed and buy the other Factor that has underperformed.
But this takes knowledge of how Factors work and my recommendation was to at least read a primer book - The Ultimate Guide to Factor-Based Investing by Berkin and Swedroe. This post is not sufficient to make you proficient in Factor investing.
Otherwise, investors are better off with broad and well-diversified ETFs such as Vanguard Total World ETF (VT) $全球股市指数ETF-Vanguard (VT.US)$ for the world, Vanguard S&P 500 ETF (VOO) $标普500ETF-Vanguard (VOO.US)$ for US and iShares Core MSCI China ETF (SEHK:2801) $安硕中国 (02801.HK)$ for China. The reason for US and China is because they are the two largest economies in the world and getting exposure to both would mean your portfolio reflects close to the entire world.
And if you are still insistent on buying Factors ETF, you can carve out a satellite portfolio. You can make an educated bet on a particular Factor ETF that is going to outperform. Even if you are wrong, your core portfolio will still carry you through.
It was heartening to see the community joining the event from different time zones. Do check out Finimize as I like their focus on microlearning. Just like this bitesize post, they break up finance topics into 2-3mins modules for easy reading or listening.
With more than 2,000 ETFs listed in the US alone, the problem today is paradox by choice, and investors have the fear of choosing the wrong ETF.
You can select an ETF based on geography, asset class, sector, theme, Factors and more. The focus here is Factors.
What are Factors? Factors came from academia research whereby the professors used data to prove (or disprove) certain investment styles of metrics are able to deliver higher returns. It is quantitative and data-driven.
For example, does PE ratio work? They would test this metric against all the stocks. It is considered a Factor if it is able to show higher returns. But to be clear, Factors are not metrics. You can call it a style. More correctly, PE ratio is typically used in value investing and hence, Value is the Factor here. And the Value Factor can be expressed by other metrics besides PE ratio.
There are many Factors but the key ones are Value, Quality, Momentum, Size and Minimum Volatility.
I was asked which Factor would outperform in 2022 and my answer was Value.
There were two reasons. First, Value and Growth (can be represented by the Quality Factor) are opposite sides of the same coin - when Value does well, Growth doesn't and vice versa. Growth has been outperforming well in the past few years while value lagged.
That was because Growth benefit in a low interest rate and low inflationary environment - the future value of Growth stocks are discounted at a smaller amount to today's dollars. But now the interest rate regime has changed. Higher rates would now discount future value in larger amounts. Value doesn't have this discounting problem as the value already exist today.
The second reason is inflation. Many of the commodity-related stocks are Value stocks, for example, the oil and gas stocks. And you can see Buffett loading them up in recent months because they are still cheap. Hence, Value stocks can have a higher chance to prosper if inflation problem remains and Vanguard Value ETF (VTV) $价值股ETF-Vanguard (VTV.US)$ is one of the most popular Value ETFs.
Should investors diversify by Factors too? Yes, this is because no one Factor can outperform all the time and it is not possible to guess which Factor is going to outperform next. Putting counteracting Factors together (such as Value and Quality) would make sense. The higher non-correlation the better. This is where one can do rebalancing regularly to capture the capital gains - Partially sell the Factor that has performed and buy the other Factor that has underperformed.
But this takes knowledge of how Factors work and my recommendation was to at least read a primer book - The Ultimate Guide to Factor-Based Investing by Berkin and Swedroe. This post is not sufficient to make you proficient in Factor investing.
Otherwise, investors are better off with broad and well-diversified ETFs such as Vanguard Total World ETF (VT) $全球股市指数ETF-Vanguard (VT.US)$ for the world, Vanguard S&P 500 ETF (VOO) $标普500ETF-Vanguard (VOO.US)$ for US and iShares Core MSCI China ETF (SEHK:2801) $安硕中国 (02801.HK)$ for China. The reason for US and China is because they are the two largest economies in the world and getting exposure to both would mean your portfolio reflects close to the entire world.
And if you are still insistent on buying Factors ETF, you can carve out a satellite portfolio. You can make an educated bet on a particular Factor ETF that is going to outperform. Even if you are wrong, your core portfolio will still carry you through.
It was heartening to see the community joining the event from different time zones. Do check out Finimize as I like their focus on microlearning. Just like this bitesize post, they break up finance topics into 2-3mins modules for easy reading or listening.
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