Contributor, Benzinga
April 27, 2023

Factor-based exchange-traded funds (ETFs), also known as smart beta ETFs, are a type of exchange-traded fund that aims to provide investors with market-beating returns by focusing on specific investment factors. These factors can include market capitalization, value, growth, momentum and low volatility. Unlike traditional ETFs that are designed to track a benchmark index, factor-based ETFs are designed to exploit market inefficiencies and deliver superior returns.

How Factor-Based ETFs Work

Factor-based ETFs follow a rules-based approach that aims to capture specific market factors that have historically been associated with higher returns. For example, a value-based ETF will invest in companies that are undervalued by the market and have the potential to generate higher returns when the market realizes their true value. Similarly, a momentum-based ETF will invest in companies that have outperformed the market in recent months and have the potential to continue their upward trend.

To identify and select stocks for inclusion in a factor-based ETF, fund managers use a combination of quantitative and fundamental analysis. They analyze financial ratios, earnings reports and other fundamental data to identify companies that meet their specific factor criteria. The ETF is then constructed to hold these selected stocks in proportion to their weightings in the underlying index.

Benefits of Factor-Based ETFs

One of the primary benefits of factor-based ETFs is their potential to deliver superior returns compared to traditional index-based ETFs. By focusing on specific factors, such as value or momentum, factor-based ETFs can outperform the broader market in certain market conditions. For example, a value-based ETF may perform well during periods of market volatility, while a momentum-based ETF may perform well during a bullish market.

Factor-based ETFs also offer investors a way to diversify their portfolios beyond traditional market cap-weighted ETFs. By investing in a variety of factors, investors can spread their risk across multiple investment strategies, reducing the impact of any one factor's underperformance. Factor-based ETFs also can be used to tilt a portfolio toward specific investment objectives, such as growth or income.

Risks of Factor-Based ETFs

While factor-based ETFs can offer investors the potential for higher returns, they also come with some risks. One risk is that the targeted factors may not perform as expected, leading to underperformance relative to the broader market. For example, a value-based ETF may underperform during a period of economic growth, as investors favor growth stocks over value stocks.

Factor-based ETFs also tend to have higher expense ratios than traditional index-based ETFs, as the cost of the additional research and analysis required to identify and select stocks for inclusion is passed on to investors. The increased complexity of factor-based ETFs also may make them more difficult to understand and evaluate.

What are Factor Based ETFs?

Factor-based ETFs are exchange-traded funds that are designed to track indexes composed of securities selected based on specific investment factors. These factors may include attributes such as value, growth, momentum or low volatility. The idea behind factor-based investing is that certain investment factors can help to explain the differences in returns between individual stocks or securities.

Factor-based ETFs typically track indexes that are constructed using rules-based methodologies, such as a stock's price-to-earnings (P/E) ratio or its dividend yield. This allows investors to gain exposure to specific investment factors without having to engage in the time-consuming and potentially risky task of picking individual stocks.

Frequently Asked Questions


How do you know which investment factor to choose?


Choosing which investment factor to invest in is a personal decision that should be based on your investment goals and risk tolerance. Do your research and understand the potential benefits and risks associated with each investment factor before making a decision.