Factor ETFs: A Liquidity Sleeve Aligned with Your Investment Process

How can Investment Counsellors and Family Offices best utilize factor ETFs as a component of their investment processes? In this article, Erika Toth, Director, Institutional & Advisory, Eastern Canada, breaks down the benefits of four different factors, sheds light on BMO’s screening processes, and discusses how factor ETFs may complement firms’ core competencies.

Many Family Offices and Investment Counselling firms have well-honed investment processes when it comes to Canadian and U.S. equity markets. However, there may be situations where factor ETFs can complement these well-honed core competencies. Some of these scenarios may include:

• As a solution for smaller accounts
• As a liquidity sleeve
• As a diversifier, with factor ETFs potentially providing easy and low-cost market access to International (EAFE) and Emerging Markets (EM) equities in alignment with the firm’s investment process and goals
• To express views on currency; many factor ETFs offer the choice of investing in hedged-to-CAD or unhedged versions, as well as, in some cases, a U.S. dollar (USD) version

The value proposition of factor ETFs is simple: they offer the potential for outperformance and/​or reduction of risk versus the benchmark, often for a fraction of the cost of an active strategy.

Determining which Factor ETF is Right for Your Investment Process

When considering factor ETFs, a first step is to examine the screening rules to determine which factor best aligns with your or your firm’s own investment process when selecting equities. The following may provide a useful starting point:

Low Volatility:

• Primary concern is to identify companies that are less sensitive to the business cycle, less volatile than the broad market, and reduce downside exposure.
• Screen for stable, mature companies, mostly in the large cap space, with the lowest betas.
• Implement a cap on the weight of an individual company in the portfolio, as well as on each sector, to mitigate risk.
• Tends to result in portfolios heavier in Consumer Staples, Utilities, and Health Care companies. At times, investors may wish to complement with satellite positions that will provide more exposure to sectors with higher volatility profiles, such as Technology, Energy, or Financials.

BMO’s Low Volatility ETFs¹

As of January 5, 2024.

Performance

As of December 31, 2023. Past performance is not a guide to future performance. Performance is shown net of fees, in the currency of the respective share class with dividends reinvested.

Dividends:

• Stable and mature large cap companies with a history of paying and growing dividends.
• To ensure that the ETF is not a ​“yield trap,” certain quality metrics are considered. For instance, companies must have an investment grade credit rating (BBB or better).
• Dividend sustainability: dividend payout ratio is examined (dividends/​operating cash flows).
  • Companies with a relatively lower payout ratio are favoured as they are less likely to cut dividends in the future.
  • Companies with stable earnings tend to naturally score higher on this metric
• Only then is the resulting list of names yield-weighted.
• To manage portfolio concentration risk, there is a 6% cap on any individual stock, as well as sector concentration rules.
• When compared to benchmark indices, these screens tend to result in a portfolio with a slight Value tilt.

BMO’s Dividend ETFs¹

As of January 5, 2024.

Performance

As of December 31, 2023. Past performance is not a guide to future performance. Performance is shown net of fees, in the currency of the respective share class with dividends reinvested.

Quality:

• These ETFs tend to hold stable and mature companies with sustainable competitive advantages, and thus higher growth potential versus their peers.
• MSCI High Quality Indexes use three key metrics: profitability, stable earnings growth year-over-year, and low leverage.
• Profitability: MSCI Quality Indexes use Return on Equity (ROE) to measure a company’s profitability.
• Stable earnings growth year-over-year; this will tend to favour non-cyclical businesses with higher earnings quality.
• Cash rich companies with strong balance sheets: MSCI Quality Indexes screen for low financial leverage (low Debt/​Equity ratio).
• The Quality factor tends to be more growth-oriented, therefore valuations tend to be slightly higher versus other factors.
• Tends to result in a higher weight to Information Technology and Consumer Discretionary sectors, and lower weights in Financials, Real Estate, and Utilities, as these are more leverage-intensive businesses.

BMO’s Quality ETFs¹

As of January 5, 2024.

Performance

As of December 31, 2023. Past performance is not a guide to future performance. Performance is shown net of fees, in the currency of the respective share class with dividends reinvested.

Value:

• The value investing school of thought became widely known after economist and researcher Benjamin Graham first wrote on it extensively the 1930s. It is founded on the practice of identifying mispriced securities that may be trading at a discount to their fundamental value.
• The key is to apply screens that identify companies trading on the cheap versus their peers but are not ​“cheap for a reason” (i.e., ​“value traps”).
• MSCI Value Indexes combine three core value metrics to achieve this:
  • Low forward price-to-earnings (P/E) ratio: to identify companies that are less expensive than their peers with similar earnings projections.
  • Low price-to-book (P/B) ratio
  • Low enterprise value (EV) and operating cash flows (OCF). Enterprise value considers all sources of a company’s capital: debt and equity. Therefore, EV and OCF tend to screen out companies that are the most highly levered and tends to favour companies with higher operating cash flows and therefore higher earnings quality.

Tend to perform well during periods of economic recovery and rising interest rates.²

BMO’s Value ETFs¹

As of January 5, 2024. 

Performance

As of December 31, 2023. Past performance is not a guide to future performance. Performance is shown net of fees, in the currency of the respective share class with dividends reinvested.

BMO’s factor ETF suite rebalances twice per year.

MSCI ACWI Factor Performance

BMO is the largest provider of factor ETFs to the Canadian marketplace,³ and we are eager to support you and your clients’ portfolios with our expertise and insights.

To learn more about factor-based investing, or receive other trading insights, reach out to your BMO ETF Specialist at their email address or via telephone at 1−877−741−7263.

¹ Definitions:

Annualized Distribution Yield: The most recent regular distribution, or expected distribution, (excluding additional year end distributions) annualized for frequency, divided by current NAV.

DIST YIELD = Distribution Yield. The Frequency of distribution: M=Monthly Q=Quarterly A=Annually

O = Optionable ETFs 

Duration: A measure of sensitivity of bond prices to changes in interest rates. For example, a 5 year duration means the bond will decrease in value by 5% if interest rates rise 1% and increase in value by 5% if interest rates fall 1%. Generally, the higher the duration the more volatile the bond’s price will be when interest rates change. 

Risk Rating: Generally, the risk rating is based on how much the ETF’s returns have changed from year to year. It doesn’t tell you how volatile the ETF will be in the future. The rating can change over time. An ETF with a low risk rating can still lose money. For more information about the risk rating and specific risks that can affect the ETF’s returns, see the​“Risk Factors” section of the ETF’s prospectus. 

YTM: Yield to Maturity (YTM) is the discount rate that equates the present value of a bond’s cash flows with its market price (including accrued interest). The measure does not include fees and expenses. 

Mgmt. Fee: Management Fee (Mgmt. Fee) is the annual fee payable by the fund and/​or any underlying ETF(s) to BMO Asset Management Inc and/​or its affiliates for acting as trustee and/​or manager of the fund/ETF(s).

² Vitali Kalesnik, ​“Value in Recessions and Recoveries,” Research Affiliates, June 2020.

³ National Bank of Canada Financial Markets, as of December 31, 2023. Measured by AUM; excludes dividend/​income ETFs (which may or may not be considered factor ETFs).