How To Give Your Passive Investing Approach Some Much-Needed Oomph

If last year taught us anything, it’s that passively investing in a benchmark stocks or bonds index can backfire, sometimes spectacularly. But that doesn’t mean you should shimmy to the sidelines whenever inflation and interest rates move higher. Instead, you could consider a more targeted approach to investing. Factor investing can give you that: it aims to identify stocks that have specific characteristics that are associated with bigger returns and lower risk. So let’s take a look at how the most popular factors have performed this year, and which ones might do best going forward…

So what are the popular factors and how are they doing now?

The most-loved “smart beta” or factor investing styles are quality, momentum, minimum volatility, value, and size. They’ve been statistically proven, persistent drivers of higher returns; plus they’ve been shown to reduce risk and volatility, and provide improved diversification.

Factor strategies and their objectives. Source: BlackRock.

These days, ETFs make it pretty easy (and inexpensive) to access these factor investing styles, which previously would have been available only to professional investors.

Here’s how the big ones have performed this year…

Performance of different factor strategies, so far this year. Source: Bloomberg.

1. Quality. The iShares USA MSCI Quality Factor ETF (ticker: QUAL; expense ratio: 0.15%) is up 13.6% since January, with quality – an investing style that aims to identify profitable companies with strong balance sheets – checking in as the best-performing factor so far this year by some margin.

When you look at the top holdings in the USA MSCI Quality ETF – Nvidia, Apple, Microsoft, and Visa – it’s little surprise that its performance has been so strong. Mega-cap tech has been on a tear all year, boosted by investors’ booming appetite for all things AI.

2. Momentum. The worst-performing factor of the lot has been momentum, with the iShares USA Momentum Factor (MTUM; 0.15%) down 5.59% over the period.

Now, the current top holdings of the Momentum Factor ETF are Microsoft, Meta, and ExxonMobil, so it's a little surprising that its performance has been so poor. But if you look at the stocks that were at the fund’s top holdings at the end of last year – Eli Lilly, United Healthcare, Exxon Mobil, Chevron, Merck, and Abbvie – it sheds some light. Energy stocks have done especially poorly this year as the oil price has declined, and although Eli Lilly has done well this year, many stocks that lit up the market last year have been disappointing so far this year.

See, the momentum ETF rebalances its holdings just twice a year – at the end of May and the end of November – so it missed the rally in the mega-cap stocks in the first five months of the year, although it will benefit if they continue to rally from here. It’s always important to understand how the ETF you choose to buy is managed, and which names are bought and why.

3. Minimum volatility. Across some of the more middling performers, the iShares USA Min Vol Factor ETF (USMV; 0.15%) has also trailed the S&P 500 this year – as it consists of stocks that have lower volatility – or “beta” – than the overall market. The current beta of the Min Vol ETF is 0.75, which means that in theory, the ETF should move 0.75% higher if the overall market moves up 1%. As the S&P 500 rally has been driven by a relatively small group of big-cap tech stocks this year, the minimum volatility strategy has been at something of a disadvantage.

4. Value. The iShares MSCI USA Value Factor ETF (VLUE; 0.15%), too, has managed only a paltry 1% return so far this year. Its valuations remain cheap though, trading at a 10.8x price-to-earnings (P/E) ratio, much cheaper than the wider market, which is trading near 18x P/E. That cheap valuation does look really attractive but there’s a risk that valuations may stay cheap, especially if earnings come under pressure next year in an economic slowdown.

5. Size. The iShares MSCI USA Size Factor (SIZE; 0.15%) has managed a respectable 4.5% gain this year. It invests in a few big and mid-size companies, but has a tilt toward small-cap, lower-risk stocks.

What happens next?

It’s tough to figure out which of these factor strategies is going to perform the best going forward. And the recent divergence between them isn’t a purely US story: it’s showing up in international markets too. The iShares MSCI EAFE Growth ETF (EFG; 0.36%), for example, is up 12.4% this year, and the iShares MSCI EAFE Value ETF (0.34%) is up 5%.

BlackRock has tried to solve this puzzle by creating the multifactor iShares US Equity Factor ETF (LRGF; 0.08%), which provides diversified exposure to several factors – value, quality, momentum, low volatility, and small size – and is designed to be used as a stand-in for a core US stock holding. It’s up a respectable 12.5% this year and is cheaper to own than those single-factor ETFs.

But if you’re looking to choose a single factor that might do well, you might want to consider longer-term returns. This chart looks back five years to compare the performance of the different factors.

Factor performance comparison over the past five years. Source: Bloomberg.

The key column to look at is the “total return” because that includes dividends that are assumed to be reinvested into more shares of the same ETF – taking advantage of the power of compounding. Quality continues to lead the pack here, with the iShares MSCI USA Size Factor ETF coming in second. The more balanced and mixed iShares US Equity Factor comes in third, with value and momentum lagging behind.

As all single-factor ETFs have attractive characteristics, buying some of the more balanced Equity Factor ETF seems a sensible approach. Still, the strong and consistent performance of the Quality Factor ETF looks really appealing and cannot be ignored.

Although when interest rates increased rapidly last year, quality was actually the worst-performing factor – as the present value of their expected future cash flows got knocked around by the higher interest rate environment. More recently, although near-term interest rate expectations have moved higher, quality has continued to outperform, with many of those companies well-positioned for the AI transformation, more than offsetting any concerns about higher interest rates.