Factor Investing with ETFs

There is a better way to build an index fund portfolio than accepting the market cap weights of stocks.Simplicity is a beautiful thing when it comes to investing.

Unfortunately, there is an inevitable trade-off between simplicity and optimization. The dialogue on ETF investing in Canada has shifted heavily toward simplicity. In the process, some of the most important research on asset pricing and portfolio management has been cast aside. This paper is designed to bring attention back to that research.

Certain types of stocks have been proven to deliver higher expected returns due to their exposure to additional risks. A traditional market-cap weighted index fund only offers exposure to market risk. Market risk is an important risk, but there are other risks that are at least as likely to deliver excess returns.

Combining several of these risks in a portfolio has another benefit: not all of the risks will perform the same way over time. Diversifying across different risk factors may be even more beneficial than diversifying across geographic regions.

Unfortunately, it is not as easy as purchasing a nicely packaged factor ETF. The race to the bottom for pricing on market-cap weighted ETFs has forced ETF companies to come up with ways that they can attempt to add value. The result has been the proliferation of ETFs with relatively high fees containing the word “factor” in their product name. The challenge for investors is that calling a fund a “factor fund” does not always deliver on factor premiums, especially after costs.

In this paper we will introduce some of the most common factors and the data supporting their use in portfolios. We will then examine Canadian listed factor ETFs; we will ultimately conclude that they are not worth their fees (sorry to give away the ending of that section). Finally, we will look at alternative methods to capturing factor premiums using carefully selected low-cost small cap and value ETFs, and we will propose an ETF model portfolio using these funds.