Factor Based ETF’s – The New Kid on the Block

The active versus passive debate will go on without a clear winner.

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There has been a long running debate between actively managed funds and those that are passively managed. Active funds use professional money managers who research stocks and build a portfolio designed to seek to deliver superior returns. Passively managed funds generally invest in a portfolio of stocks determined by a given index, such as the S&P 500.

There is a long list of pros and cons to each form of investing. Critics say actively managed funds have trouble beating their index because expenses are too high. Yet passively managed indexed funds also underperform their benchmark because of trading costs and expenses. Is there a way to capture the good points of each style?

There is a growing category of Exchange Traded Funds (ETFs) called “factor-based strategies” that is not totally passive or active. These ETFs reweight indexes in favor of factors other than market capitalization. They are still considered passively managed because the fund must follow the reweighting rules once they are established. The rules are often formulated based on academic research going back to the 1960s. This research seeks to identify a broader set of fundamental drivers behind excess returns in certain stocks over different market cycles. Factors such as earnings quality and momentum growth have actually shown negative correlations to each other. Some academics believe returns can be improved with less volatility when these factors are followed.

The active versus passive debate will go on without a clear winner because both choices have clear advantages. Factor-based ETFs have not been around long enough to prove they can live up to expectations. We believe investors should consider passive fund options and active investment managers across all asset classes. Ongoing expense is an important criterion where passive investing has a significant advantage. Factor-based ETFs might be the solution giving us an active management boost with the lower cost of passive investing.

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