We’ve got an exciting issue for you this month.
Because of the release of our report on the Fidelity All-In-One ETF FEQT (you can view the report here), I’ve had many members reach out to me and ask to cover “factor funds” in-depth.
I believe these are fascinating funds. If you look at the shortlist of funds we have here at ETF Insights, you’ll notice a large chunk of them are indeed factor funds.
In this month’s issue, I will go over a brief explanation of factor investing and then go into detail on each specific factor available to investors, as well as some individual options for each factor.
Before I start, I want to highlight the usefulness of the Q&A. Members can log into their accounts and ask me questions about anything related to investing. This is the number one resource on the platform, and members who utilize it will get the most out of ETF Insights.
To use the Q&A, simply login to your account, hover over the ETF Insights menu option, and select “Q&A.”
One announcement before we start
Many ETF Insights investors have requested access to our private Discord so they can communicate in real time with us.
We are currently working on this integration, and it will be opened up this month.
Factor Funds – What Are They?
There have been particular metrics tracked among publicly traded companies that, in the past, have led to historically higher returns or lower overall volatility.
In short, factor funds aim to take advantage of particular metrics to drive higher returns for their unitholders.
Although there are a wide variety of factor funds available, some of the most popular are:
- Momentum Funds
- Low Volatility Funds
- Value Funds
- High-Quality Funds
- Size (Market Cap) Funds
These funds are actively managed, which causes many investors to turn away from factor funds immediately. There is an extensive amount of negative stigma around actively managed funds these days, particularly regarding their underperformance relative to broader market indexes.
However, these are not actively managed funds in the sense that the fund managers are simply buying and selling stocks they see fit. These funds follow a strict set of criteria based on their underlying factors. If the stock does not meet the fund’s criteria, it cannot be purchased, even if the fund managers like the prospective stock.
Let’s dig into the different types of factor funds and some of the best options for investors
Momentum Funds
I’ll preface this section by saying that momentum funds are the trickiest of the bunch when it comes to factor funds. Although they are no doubt the funds that promise the highest level of outperformance due to their strategy, they also pose the highest levels of volatility.
The concept of these funds is simple:
Stocks that are going up in value at an accelerated pace are likely to continue to go up in value.
These funds will typically utilize a combination of pricing and technical indicators to select the basket of stocks they want to invest in.
During a bull market, particularly one that is aggressively bullish, we can expect a fund like this to be one of the better-performing factor funds.
Look no further than the Invesco S&P 500 Momentum ETF (SPMO). The fund has returned a whopping 37% year-to-date, nearly doubling the returns of the S&P 500.
How does it do this? It isolates out all stocks inside the S&P 500 exhibiting strong “momentum” characteristics. Then, it takes a more concentrated position in those 100 or so stocks versus 500 of the actual index.
This means more exposure to the best performers on the year, such as NVIDIA, Microsoft, Meta, Amazon, Broadcom, Berkshire, etc.
However, as I mentioned earlier, these types of factor funds will have, with little doubt, the highest levels of volatility and drawdowns among any of the factor funds. For instance, the 8%~ drawdown the markets witnessed from July into August this year. Invesco’s momentum fund experienced a 65%~ larger drawdown.
My overall thoughts on momentum funds, who they’re for, and some of the best
Out of all the factor funds available, momentum funds are likely the ones that most retail investors may want to avoid unless you have shown in the past or are reasonably confident you won’t make panic-driven decisions in the event of a drawdown.
I know it may sound odd saying this with the exceptional performance they’ve put up. But the volatility can be a hard thing to swallow for many. Although these funds will outperform during bull markets, they tend to underperform during bear markets.
The heightened risk of volatility is even more amplified now, as many stocks showing strong momentum at this point are trading at heightened valuations, which typically results in larger drawdowns in the event of a correction.
These funds typically carry relatively high fees due to the trading costs involved inside of the fund. Because momentum factors can change on a dime, most of these funds will rebalance quarterly, with some getting away with semi-annually.
We don’t have too many momentum ETFs traded on the Canadian exchanges yet. New funds are popping up quite often, but for now, the Fidelity US Momentum ETF (FCMO) is undoubtedly the most popular. If you wanted to explore more options, you’d likely have to head south and look at US ETFs.
High Quality Factor
Out of all of the factor ETFs available on the market today, high-quality ETFs are my personal favourite. The elements used to construct these funds are data I regularly use to analyze individual equities.
Although high-quality funds will differ in which types of elements they prefer the most if you see a fund with high-quality in the name, there is a good chance it picks its underlying holdings utilizing:
- Returns on equity
- Returns on invested capital
- Earnings and free cash flow growth
- Attractive debt profiles
Stocks tend to follow earnings, and companies with high returns on capital and manageable debt levels tend to be able to grow earnings at a robust pace. For this reason, high-quality factors have been known to drive outperformance.
High-quality factor funds don’t stop at equities, either. If you’re looking for fixed-income options, there are a number of high-quality funds that include bonds from stocks that would qualify for the exact criteria listed above.
One of Canada’s most prominent high-quality funds is the BMO MSCI USA High Quality ETF (TSE:ZUQ). It is also a shortlisted ETF here in Stockrades ETF Insights, as I believe it is one of the strongest ETFs in the country for US exposure.
The fund has outperformed the S&P 500 since its mid-2015 inception and has also outperformed popular Canadian S&P 500 funds like VFV.
A caveat to the chart above, however: The outperformance is still there but not as wide as it looks in the chart above. This is because currency fluctuations have caused a big boost in terms of returns relative to USD indexes like the S&P 500.
ZUQ does have a USD-traded version that I could compare on a constant currency basis. Still, it hasn’t been around long enough to get any sort of reliable data.
These funds will typically not be rebalanced as often as a momentum fund. That is because the quality factors these funds use are unlikely to change over 3 or 6 months. Returns on equity, earnings growth, and debt profiles typically do not deteriorate as quickly. As such, you may see most of these funds rebalance annually.
My overall thoughts on high-quality funds, who they’re for, and some of the best
As mentioned, out of all the factor funds available, I believe these are the best suited for long-term investors looking to take advantage of companies that meet a particular set of criteria often correlated with strong returns.
As the popular saying goes, over the short term, the market is a voting machine, but over the long term, the market is a weighing machine. Over the long term, that weighing machine tends to lean towards companies that provide high returns on capital and strong earnings and cash flow growth.
These are the exact equities these high-quality funds target, and I’m a big fan.
There are many more variations of funds investors can choose when it comes to high-quality funds. USA, International, and Canadian come to mind.
I’m a big fan of BMO’s USA High Quality ETF (TSE:ZUQ). If you’re looking for global exposure, I’m also a big fan of BMO’s All Country High Quality ETF (TSE:ZGQ). Below is a return chart of ZGQ versus the MSCI World Index. Again, currency impacts widen the outperformance, but it has outperformed nonetheless.
Both funds are shortlisted here at ETF Insights, so you can log in to your account and head to the ETF Report section to read both in-depth reports.
Value Factor
Value investing is a strategy that has fallen out of favour over the years but remains relatively popular.
The premise is simple. Identify stocks that are trading below their intrinsic value, buy them, and reap the benefits over the long term.
Value factor funds typically have a strict set of criteria to be included in the fund based on the following:
- Attractive price-to-earnings and price-to-book ratios
- Strong earnings and free cash flow yields
- Strong enterprise value-to-cash ratios
Every fund will vary in the overall selection, including what is deemed an “attractive” ratio.
This is where the difficulty in the value factor funds comes in for me. Intrinsic value and stock valuation overall are subjective. An in-depth analysis of an individual security from two investors can lead to different perspectives on whether or not a stock is undervalued.
There is also an added element that a company’s valuation ratios may be low for good reason. Companies that are struggling tend to trade at what looks to be attractive valuations, but there isn’t really much value there at all. This is often called a “value trap” and can also often be accompanied by a higher-than-average dividend yield, luring many investors in.
If we look to the BMO MSCI USA Value ETF (TSE:ZVU), we can see its struggles relative to the S&P 500 index, especially in a post-pandemic environment.
The fund’s top holdings contain many companies trading at seemingly attractive valuations. However, when I look at many of them, including Cisco, AT&T, Intel, IBM, and Verizon, I don’t really see all that much value. Sure, price-to-earnings ratios look attractive, but the underlying businesses don’t really look all that attractive.
Again, this is my point of view, which is why valuation is so subjective. As the saying goes, one man’s trash can be another man’s treasure.
My overall thoughts on value funds
Although I certainly don’t believe the markets are 100% efficient, I do believe they reward the strongest companies and punish the weaker performers.
As a result, I tend to lean towards the high-quality factor over the value factor almost 100% of the time. If you dig deep into the top holdings in many of these value funds, you’ll notice a few things:
- Earnings growth is slowing/declining
- Returns on investing capital are declining
- Debt levels are rising
For this reason, the value factor tends to lean towards its top holdings undergoing a bit of an operational turnaround and getting back on track. Which, don’t get me wrong, does happen. However, in my opinion, investors would be better off focusing on the companies with stronger current operations.
The Low Volatility Factor
The Low Volatility factor strategy is a popular one, and in terms of Canadian ETFs, has some of the strongest-performing funds in the country. This is primarily because some of the fastest earnings growers in the country here are blue-chip companies with incredible economic moats, strict regulations, and little competition.
In the end, most of the stocks in these funds end up meeting the following criteria, which are typically must-haves for low-volatility funds:
- Low betas
- Smaller maximum drawdowns
- Stable earnings growth
- Strong historical risk-adjusted returns (Sharpe ratio)
My focus on the low volatility side of things will be the BMO Low Volatility Canadian Equity ETF (TSE:ZLB), which I believe is not only the best low-volatility fund in Canada but also one of the best funds in Canada, period.
Before the COVID-19 pandemic, ZLB’s Maximum Drawdown, which means the most the fund lost over a particular period of time, was 10.83%.
The TSX, on the other hand, had a max drawdown of 26.41%.
I am isolating the COVID-19 pandemic crash of 2020 out of this because of how short-term and panic-driven it was. I don’t believe counting that short drawdown would be an accurate measure of how truly low volatility ZLB has been.
Many of the fund’s top holdings include major Canadian grocers, banks, utilities, waste disposal, and railroad companies. Companies that, regardless of economic conditions, have typically driven stable earnings growth and, as a result, are not as prone to large drawdowns.
At its core, this is what low-volatility factor funds aim to achieve. Generate the largest returns possible while mitigating overall portfolio volatility.
When we look to the returns of ZLB relative to the Canadian market, it has done just that, nearly doubling the returns of the index since 2011.
My overall thoughts on high-quality funds, who they’re for, and some of the best
Low volatility funds are strong options for those who are a bit risk-averse but still would like 100% equity exposure.
There is a unique situation here in Canada where our lowest volatility options are often our best performers. That is because of the oligopoly nature of many industries here in Canada. Our banks, railways, utility companies, and grocers are often immune to competition.
This allows them to do two things: grow earnings at a very predictable pace, and reinvest capital back into the business without worry of the capital being ill-spent because of the high barriers to entry.
This is precisely why BMO’s Low Volatility Canadian fund, ZLB, has been one of the best performer Canadian funds over the last 14+ years, and is a shortlisted ETF here at ETF Insights.
The fund has more than doubled the returns of the TSX Index, and before the torrent pace of technology companies in the United States post-pandemic, was keeping up with the S&P 500 as well.
Not only is ZLB one of the best low volatility funds around, but I do believe it is one of the strongest ETFs in the country, period.
Overall, factor funds provide a unique way for investors to get exposure to higher quality companies
For long-term investors, I’m a big fan of the Low Volatility and High-Quality factor funds offered today, and I expect the popularity of these funds to continue in the future, leading to a higher variety of funds for investors to choose from.
In terms of Momentum funds, these are more suited for investors with a higher risk-tolerance and although they can certainly outperform in a bull market, they will likely undergo much higher volatility during drawdowns. Think of these as higher-risk, higher-reward satellite holdings inside of a portfolio of strong core options.
And in terms of value funds, these are my least favorite. I’ve scanned quite a few of them over the last month of creating this newsletter, and I struggled to find one that I really liked. The bulk of the holdings inside of them are companies that are currently undergoing struggles operationally, leading to perceived lower valuations. I’d much rather take the High-Quality route and opt for more expensive, but better performing businesses.
