Pure-Factor ETFs Poised to Shine in Market Downturn

An article in Bloomberg argues that pure factor ETFs, those that “stick closer to the academic version of factors,” have the potential to shine in a market downturn.

“The multiyear run-up has made life difficult for purer factor ETFs from independent issuers, which have been overshadowed by watered-down products from the likes of BlackRock and Vanguard,” the article notes, explaining that some ETFs dilute factors “to the point where they mostly just deliver market returns.” Advisers don’t like the high tracking error of the purer funds or lack the patience needed to “truly capture a factor,” it says, but suggests that a bear market could change the landscape.

“Watered-down factor ETFs tend to behave more like the market because they deviate from purer factor exposures through adjustments such as market-cap weighting or volatility screens,” the article says. While this can help performance when the market rises, it offers closer to market yields during declines and has drawn criticism for engaging in “closet indexing.” The purer factor ETFs, on the other hand, “tend to shine in down or volatile markets,” the article reports (citing specific examples).

According to the article, “high-conviction ETFs show value-investing approach isn’t dead. “In the past two years,” it says, “77% of value ETFs have trailed the S&P 500, and flows show that investors prefer to hug broad indexes. But a performance breakout could prompt an asset shift.” It adds that, while the goal of all value ETFs is to identify undervalued securities, there is no consensus on methodology.