ETF investors re-engage with factors, focus on quality

At a February exchange-traded fund conference, attendees and speakers alike wondered out loud, "What a difference a year makes." Talk of ESG, thematics and cryptocurrency had faded. Fundamentals, low cost and diversification were back. And muffled under some of those conversations was a harken back to last decade's ETF gold rush: factor funds.

"The crowd had moved on to other strategies," said Bryan Armour, director of passive strategies research for North America at Morningstar Research Services LLC in Chicago. "Flows to factor ETFs continued, but far more muted."

Factor and multifactor ETFs attempt to isolate (or combine) any number of investment metrics that are believed to be sources of return. The academic literature is replete with evidence and debate over which factors are legitimate and which are fanciful.

The most notable — size, momentum, value, volatility and quality — are the focus of work by Professors Eugene Fama of the University of Chicago Booth School of Business and Kenneth R. French at the Tuck School of Business at Dartmouth College.

"2022 was an unusual year, marked by significant reversals in factor performance," said Anu Ganti, senior director, index investment strategy at S&P Dow Jones Indices in New York. "For example, low volatility over high beta; value over growth; and equal weight over the cap-weighted S&P 500," she said.

Now, as layoffs and concerns about a recession pepper the headlines, the quality factor is back in view.

Through Feb. 28, the 15 quality ETFs tracked by CFRA Research have added $3.5 billion in aggregate net inflows, or 8% of the $43.5 billion in total assets under management. Nearly $2 billion of that has amassed to the $12.5 billion Pacer U.S. Cash Cows 100 ETF (COWZ), and $509 million to the $4.2 billion Invesco S&P 500 Quality ETF (SPHQ).

Assets across factor strategies totaled nearly $750 billion at the close of February, according to CFRA, with nearly half of that in dividend funds and one-sixth in multifactor.

Harder to define than other Fama-French factors, quality factor products are built on the notion that some indicators of financial fitness such as cash flow, leverage and margins are available risk premiums for harvesting returns.

In a 2019 article published in the Financial Analysts Journal titled, "What is Quality?", Jason Hsu, Vitali Kalesnik, and Engin Kose (all then with investment strategist and index publisher Research Affiliates of Newport Beach, Calif.) analyzed the characteristics used by six major index providers to construct the quality factor. Their research found indexes measuring profitability, accounting quality, payout/dilution and investment deliver superior performance. On the other hand, "little evidence exists that earnings stability, capital structure, and growth in profitability are associated with superior performance," they wrote.

Moreover, limited constraints on a factor can introduce significant sector concentration. Pacer Advisors Inc.'s COWZ, for example, had 31% of its portfolio in energy stocks and 19% in materials as of March 2, according to Morningstar. That sector overweight helped contribute to a three-year annualized return of 24.6% compared to 14.1% for the midcap value category average.

Single-factor ETFs and indexes can also overlap. Invesco's SPHQ, for example, is closely tied to the momentum factor and its three-year outperformance is not as significant — 12.7% vs 11.3% for the large blend category, according to Morningstar.

"When analyzing a factor exposure, it's helpful to understand the other factor tilts," said S&P Dow Jones Indices' Ms. Ganti. "As indexing evolves, we look at combinations of factors, not silos. But it's also important to understand that indexes evolve over time, including factor correlations."

This organic nature of factor investing — along with the faded hype around smart beta/strategic beta by ETF issuers — left the door open for differentiation by asset managers pitching process-driven "quality" investing, according to Morningstar's Mr. Armour.

"We see ongoing support in actively managed ETFs," he said.

For example, the $1.8 billion U.S. High Profitability ETF, launched in February 2022 by Dimensional Fund Advisors, has added $280 million in net inflows since December. For the year ended Feb. 28, the fund was down 2.4% compared with -7% for its Morningstar large-cap blend category.

Echoing criticism of the "quality" denomination, Wes Crill, vice president and head of investment strategists at Dimensional, demonstrated in a 2022 paper that DFA's view of profitability helps to weed out some of the value traps and low profitability companies that make it into quality indexes.

"In our view, quality's substantial weight in low-profitability value stocks makes it a potentially less appealing complement to value strategies compared to a high-profitability approach," Mr. Crill said.

The $3.75 billion Avantis U.S. Equity ETF, which has a similar approach to profitability, has attracted $347 million in net inflows this year. For the year ended Feb. 28, the fund was down 4.2%.

The Dimensional and Avantis ETFs have expense ratios of 0.21% and 0.15%, respectively, a cheaper active approach relative to 0.49% for COWZ from Pacer.

"The research is robust to support factor investing," said Morningstar's Mr. Armour. "It can be helpful, but it has to be low cost."