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. Continue reading →