Vanguard: 3 Questions to Ask Clients Interested in Factor ETF Investing

February 12, 2018 — 2:02 PM EST

With factor exchange-traded funds (ETFs) garnering a lot of interest among investors and with Vanguard recently launching a suite of factor-based ETFs, the fund company is helping advisors figure out which one is right for their customers

After all, choosing a factor-based ETF that is tied to market factors can take time and a lot of due diligence given the sheer number of choices. But to narrow down the choice, advisors have to look at what would be the best securities weighting method, whether or not the factor investing should be passive or active, and if several factors provide a way to achieve the client's goals instead of a single-factor ETF.

[Check out Investopedia's Ally Invest review to learn about this low-cost broker with powerful charting tools.]

"A lot of marketing highlights the long-term performance of particular factors or strategies. But the reality is that the performance of any factor-based product, as with other forms of active management, will likely vary over time and be difficult to predict," said Doug Grim of Vanguard Investment Strategy Group in a recent blog post. "Just like a roller coaster, every factor strategy has its ups and downs. If you understand the nature of this cyclicality, you can better set your own and your clients' expectations, and that can help you make a better decision on how much of your clients' money, if any, you may want to commit to factors."

Take stock weighting for starters. According to Vanguard's Grim, when choosing a factor ETF, advisors tend to overlook the security weighting, which is something they should definitely consider. He said advisors should narrow down their search for investment products that weight stocks based on their sensitivity to specific factors such as relative price momentum or price-to-earnings ratios. That's because he said those products will give higher and more consistent exposure to the factor being targeted.

On the passive versus active front, Grim said that, while factor ETFs can be both, the index ones typically have high transparency, lower costs and are driven by the methodology of the index provider. Meanwhile, actively managed factor ETFs fall into the active selection and active implementation categories. Those employing active selection strategies to factor ETF investing try to add value by choosing stocks they think will perform better, while active implementation refers to money managers who try to reduce the trading costs and maintain better factor exposure over time by having the flexibility to make trades. With the latter strategy, managers can rebalance when they identify a decline in factor exposure, Grim said.

Advisors also have to determine if a factor ETF that is tied to several factors is better than one that is tied to a single factor. Grim said that going with a multiple-factor ETF can provide diversification benefits and can make it easier to choose. The Vanguard executive said advisors can get multi-factor exposure by assembling a collection of single-factor ETFs or one that targets stocks that look attractive when taking into account all the factors. Grim said that the latter approach may lead to less turnover and ensures that stocks aren't working against any of the targeted factors and reducing the benefit of investing in the ETF.