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May 28, 2017

Monday Morning Memo: The rise of factor ETFs in Europe

by Detlef Glow.

Exchange-traded funds (ETFs) that invest based on factor strategies have become very popular in Europe over the last three years. Investing with a factor strategy means these funds do not follow a market capitalization-weighted index. Since “factor-based strategy” is a technical term that sounds rather complex, marketing departments and media companies have named these products “smart beta ETFs,” since the factors and strategies used generate better risk-adjusted returns over time than do market capitalization-weighted indices. The main factors used in these strategies are:

  • Low volatility/minimum variance
  • Momentum
  • Size
  • Quality
  • Value

These factors have either a regional or global investment focus. In this regard these ETFs should, from my point of view, rather be called “factor investments,” and most professional investors already do so. Since larger numbers of assets under management gather more attention, a number of market observers take “plain-vanilla” dividend strategies into consideration when reporting on factor ETFs. Their rationale is that these strategies are also based on an alternative index composition; i.e., a non-market capitalization-weighted index. From my point of view this would then mean that other strategies such as environment, social, governance (ESG) or socially responsible investments (SRI) would also need to be considered in this category, which would be wrong. In addition, dividends are taken into account for the value factor and in some cases the quality factor.

Even though some products were launched quite early on, the factor-investing trend in Europe really took off in 2011. There were 27 factor-based ETFs, with combined assets under management of 248 million euros, available to investors in Europe at the end of 2011. As shown in Graph 1 the number of ETFs increased to 260, with 1.68 billion euros in assets under management, at the end of April 2017.

Graph 1: Assets Under Management (euros millions) (left scale) and Number of Smart Beta ETFs (right scale)

The rise of factor ETFs in Europe

Source: Lipper

This chart depicts the increasing popularity of factor-based products; the increasing number of ETFs was accompanied by increasing assets under management. That said, one needs to bear in mind that newly launched ETFs are normally fed with seed money to make the products attractive (buyable) for institutional investors, who normally face restrictions on the portion of a fund they are allowed to own. This may explain the more or less parallel rise in assets under management. But there needs to be real interest from investors to keep the assets under management up, since seed money is pulled off after some time.

The interest of investors in factor ETFs is shown in Graph 2. Even though the flows into these products were quite shy over the course of the years 2011 and 2012, investor interest started to take off in 2013. Over the course of 2016 we even witnessed some short-term trends in the segment of factor ETFs as investors bought low-volatility ETFs over the first seven months of the year, sold these products after the summer, and bought value strategies in Q4 2016. This move was rather surprising, since factor strategies are considered long-term investments; these kinds of strategies are supposed to generate their superior returns over a full economic cycle.

Graph 2: Estimated Monthly Net Sales in Factor ETFs (in euros million)

The rise of factor ETFs in Europe

Source: Lipper

The fact that not all factors/strategies outperform their market capitalization-weighted peers all the time may hold investors back from investing in factor products. In this regard, the European ETF industry has developed multi-factor ETFs to overcome the struggles of single strategies and to deliver a “one size fits all” solution for investors who don’t want to make timing decisions on their factor exposures in addition to their general asset allocation decisions.

Since there is only a very small offering of bond products based on factor strategies, we might see this kind of ETFs in the next product push of the European ETF industry. Even though it might be much harder to find factors in the bond market that can be exploited by investors in a systematic way, I am sure we will see such products in the near future. I am also sure that factor ETFs will be one driver of innovation in the European ETF industry, since in addition to specialist promoters (such as First Trust, Invesco Powershares, and Wisdom Tree), promoters of actively managed funds (such as Fidelity) are starting to offer factor ETFs based on proprietary index methodologies, which will increase the variety of strategies and products in Europe. This variety of investment instruments may lead to even higher investor interest in these products and to higher flows and increasing assets under management.

This article will be updated in our semi-annual market reports on the European ETF industry.

The views expressed are the views of the author, not necessarily those of Refinitiv.

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