Trackers and exchange traded funds (ETFs) that pursue a passive strategy of simply following a specified market or index have become extremely popular in recent years, as it has become common knowledge that classic stock picking does not always work.

A pure tracker that entails “buying a market,” such as the S&P 500 or the FTSE in the U.K., has its disadvantages. Although highly transparent, investors are completely exposed to the market in question and all its vicissitudes. It is not surprising, therefore, that hybrid models have emerged that are still tracker ETFs, but are deliberately biased in one or more respects. These are often referred to as “factor ETFs.”

The Workings of Factor ETFs
The concept behind a factor ETF is that by shifting away from “plain vanilla” trackers, one can improve the rate of return and/or risk level without getting into expensive and time-consuming stock picking. The shift is referred to as “bias” or “tilt.” In other words, these products are not pure trackers; they deviate to some degree from simply going up and down with the specified market.

The following factor ETFs introduced in April 2013 demonstrate how these vehicles operate:

- iShares MSCI USA Size Factor ETF (NYSE:SIZE)

- iShares MSCI USA Momentum Factor ETF (NYSE:MTUM))

- iShares MSCI USA Value Factor ETF (NYSE:VLUE)

Each iShares ETF has a particular tilt, one biased toward small firms, another toward firms whose stock value is accelerating in price or gaining momentum, and a third toward stocks that may be undervalued by the market.

The size factor ETF from iShares focuses on U.S. large- and mid-capitalization stocks "with relatively smaller market capitalization" with the idea that smaller firms tend to be overlooked. The momentum factor ETF invests in stocks with accelerating price and volume, while the value factor ETF weights securities according to four accounting variables and compares these to the parent index. These three approaches “tilt” the fund away from exposure to your chosen index. These forms of bias all make financial sense, and if properly tuned, should provide a good quasi-tracker, but one that can outperform a pure buying-the-market vehicle.

How Effective Is All This Likely To Be?
These ETFs are fairly new, so there is not much of a track record. However, the logic is sound enough that a prudent investment could pay off. Make sure that you understand exactly how the products work. The more an ETF deviates from the pure index (benchmark risk), the more appropriate it may become for sophisticated and active investors.

There are various ways of using these concepts in practice. Atlas Capital, for instance, has offered a variant of the concept, “enhanced indexing,” since the firm was founded seven years ago by Jonathan Tunney, CFA, in San Francisco. In separately managed accounts for large dollar amounts, it uses value, size and momentum, as well as short-term reversal. This latter term refers to return over the prior month, which tends to display negative serial correlation, whereas medium-term momentum displays positive serial correlation.

The Atlas portfolios use value, size, momentum and short term reversal as their factors for enhanced indexing, which they combine into a unified strategy. In other words, Atlas does not actually use the ETFs described above in their pure form, but instead has adapted the concept to its own portfolio of stocks, using a ranking system with regard to value, momentum, size and short-term reversal.

Atlas founder Tunney says the firm's factor model process enables it “to provide clients with portfolios that are liquid, transparent, low-cost and backed by years of academic research." Factor ETFs reduce the costs of traditional actively managed funds by providing a low-cost product that's still well-researched and can provide greater-than-market returns, he says.

These products are generally recommended, by the people offering them, for investors who seek exposure to other and different risk factors and “alternative beta.” Nonetheless, until they gain acceptance, the factor ETFs face liquidity issues.

Some Other Market Offerings

Plenty of other factor ETFs are in the market, as they include any common market-wide drivers of security return. Apart from the offerings of Atlas and iShares, Schwab has "Fundamental Index" ETFs, using three fundamental measures of a company, namely adjusted sales, retained cash flow and dividends plus buybacks. Its three products are FNDB, FNDX and FNDA.

FlexShares, the ETF unit of Northern Trust, launched two new fund products last year. They are based on a multi-factor model approach intended to provide a heavier emphasis on international small caps and value stocks. The products are the FlexShares Morningstar Developed Markets Ex-U.S. Factor Tilt Index Fund (TLTD) and the FlexShares Morningstar Emerging Markets Factor Tilt Index Fund (TLTE).

The Bottom Line
ETFs and trackers are here to stay, given that it is pretty much accepted that paying someone to simply “beat an index" can be counterproductive. Pure trackers have their disadvantages, however, as there is no protection from market movements. New factor ETFs offer some compromise with a bit of "tilt" away from an index. If you are more experienced or adventurous, factor ETFs may make sense as a form of diversification and potential means of enriching your portfolio.

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