Courtesy of Rosalyn Retkwa
Most ETFs are still designed to track an index passively at a low cost. But the market can support only so many ETFs that simply copy an index, and with actively managed ETFs still problematic, there is a growing category in between: ETFs that use “factor-based strategies” to reweight indexes in favor of factors other than market capitalization. Such ETFs are still in the passively managed camp because once they establish their rules for reweighting, they have to follow those rules, but they’re not plain-vanilla passive, either.
“A lot of the new index funds deviate away from market cap and try to implement strategies that add performance over the market cap performance,” says Samuel Lee, the editor of Chicago-based Morningstar’s newsletter, ETFInvestor. “The most common type of non-market-weighted strategy is the value strategy, where stocks are cheap by some sort of fundamental accounting measure — price-to-earnings, price-to-book or price-to-cash-flow,” he says. But there are a number of factors that can be used in reweighting indexes, for instance, “company size is well accepted as a factor,” he says.
The newest factor-based ETFs to hit the market are the “tilt index” funds from FlexShares, sponsored by Northern Trust of Chicago. In its product literature, FlexShares describes its tilt funds as “applying a nuanced ‘tilt’ methodology” that weights its portfolios more towards small-cap and value stocks. The funds still include large-cap and growth stocks, but “seek to counterbalance the inherent bias toward large-growth companies embedded in market-weighted strategies,” the firm says.
FlexShares launched its first tilt index fund a year ago, in September of 2011, the FlexShares Morningstar U.S. Market Factor Tilt Index Fund (TILT). As of October 18 it had $141.6 million in assets, with a one-year gain in net asset value of 30.33 percent as of September 30. This October 1, the firm launched two more tilt index funds — one, on the developed markets ex-U.S. (TLTD) and seeded with $10 million in start-up capital, and the other, on the emerging markets (TLTE), seeded with $5 million, “completing the continuum” in terms of offering “coverage of the globe,” says Shundrawn Thomas, the head of Northern Trust’s exchange-traded funds group. As to why the funds tilt the way they do, he says that “historically, the market has paid you a premium for investing in small-cap and value stocks,” and the firm believes the market is now moving towards the “next evolution” in ETF products, with “more targeted, more sophisticated investment strategies.”
The tilt ETFs may be more complex, but they are still “very competitive” in terms of their net expense ratios, both in terms of other ETFs and also in comparison to actively managed mutual funds, Thomas notes, with the U.S. ETF at 27 basis points; the developed markets, at 42 basis points; and the emerging markets, at 65 basis points.
There’s another key difference. Most indexes based on market capitalization are rebalanced just once a year, but the indexes that are used for factor-based ETFs are usually rebalanced more frequently.
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