Leverage Proven Stock Factors With These Top 3 Smart Beta ETFs

Key Points

• Researchers Eugene Fama and Kenneth French were two monumental figures who advanced our knowledge of finance by identifying "factors" that help explain stock market returns.
• QUAL, VBR, and MTUM are three ETFs built to invest in factors that have been discovered over the years.
• However, not all these factors have held up the same over the past 10 years.

While tracking the market or looking for stocks with disruptive business models can be legitimate ways to invest, another strategy takes advantage of research by individuals often regarded as pioneers in finance. Eugene Fama and Kenneth French are two professors who fundamentally shaped our modern conception of finance. In particular, they worked to improve our understanding of stock market returns.

In their research, they realized that traditional methods used to explain returns didn’t work for every stock. These aberrations were known as "anomalies." Their research aimed to identify the underlying causes of these anomalies to understand why some stocks performed better than others.

They successfully researched and attributed reasoning to these anomalies, which they called “risk factors." One way to take advantage of these risk factors is through “smart beta” investing.

“Beta” measures how a stock tends to perform in relation to the overall market. For example, a stock with a beta of one in relation to the S&P 500 means the stock’s returns tend to move in lockstep with the index.

If the S&P 500 goes up or down 10% over an extended period, the stock would also tend to move up or down 10%. A stock with a beta of two would move up or down 20%. Essentially, beta measures the amount of “market risk” to which an investment is exposed.

“Smart beta," on the other hand, aims to invest beyond market risk into the other factors that Fama, French, and others identified. Through this, smart beta investing seeks to achieve risk-adjusted returns that could outperform the overall market. Luckily, several ETFs make accessing these strategies possible.

QUAL: Investing in Profitability Has Endured

One factor that Fama and French identified is the “profitability factor," also known as quality. It states that firms with high profits, steady earnings, and low debt tend to outperform others.

The quality factor has held up particularly well. Over the past 10 years, the iShares MSCI USA Quality Factor ETF BATS: QUAL has achieved a total return of 246%, compared to 238% for the iShares Core S&P 500 ETF.

It is important to note that the actual metrics each fund uses to measure these characteristics can vary. This fund uses return on equity, the variability of earnings-per-share (EPS) growth over the past five years, and the debt-to-equity ratio.

These standards are based on the fact that the fund aims to track the investment results of the MSCI USA Sector Neutral Quality Index. Stocks are compared to others in their sector to determine which ones will be included.

VBR: Examining Size and Value

The Vanguard Small-Cap Value Index Fund ETF NYSEARCA: VBR is one whose factors haven’t held up as well over time. Fama and French identified the “size” and “value” risk factors. They found that, over time, smaller companies tend to outperform larger ones. Also, stocks priced below a measurement of their fundamental value tend to outperform overpriced stocks.

Over the past 10 years, VBR has returned 134%, much less than that of the market. One reason for this is the well-documented strength of mega-cap stocks, such as the Magnificent Seven. These stocks, with their extremely large market capitalizations, are not included in this fund now. Although they may have been at one time or another if they met the fund's criteria.

This is one aspect contributing to the underperformance of this fund. Also, research shows that, in the past 10 years, "value stocks" have underperformed "growth stocks" in the U.S. However, there were periods when value stocks outperformed, such as from June 2020 to April 2023.

MTUM: Investing in What’s Hot

Lastly, I’ll look at the momentum factor. Although this factor wasn’t identified by Fama and French, their research did influence its discovery. This factor asserts that stocks that have outperformed recently tend to continue to outperform, and that stocks that have performed poorly will continue to do so.

The iShares MSCI USA Momentum Factor ETF BATS: MTUM has slightly outperformed the market over the past 10 years. It has a total return of 240% versus 238% for the market. The focus on recent performance helps explain why the three best-performing Magnificent Seven stocks over the past twelve months—NVIDIA NASDAQ: NVDA, Meta NASDAQ: META, and Amazon NASDAQ: AMZN—are included in the fund. The other four are not.