ETFs hot on Dimensional's trail

Exchange-traded-fund companies are following in the footsteps of financial adviser favorite Dimensional Fund Advisors Ltd. and building new products around academic research to offer investors a new way to beat the market. BlackRock Inc.'s iShares, Charles Schwab Investment Management and Northern Trust Corp.'s FlexShares are among the firms that have recently launched ETFs based on investment factors such as value, profitability, size and momentum. The idea that factors such as a company's stock price relative to the market, its ability to generate a profit or how big the company is are good predictors of future performance isn't new. However, factor investing has taken off in recent years along with passive investing, though not nearly at the same torrid pace, as the shift away from actively managed equity funds continues.

Passive style

“Passive and factor investing are joined at the hip,” said Samuel Lee, an analyst at Morningstar Inc. “Passive is based on a lot of academic and finance theory that says it's impossible to beat the market. Factor investing is an offshoot of that,” Mr. Lee said. “Factor investors probably started off as Bogle-style buy-and-hold investors, then looked deeper into the research,” he said, referring to John Bogle, founder of The Vanguard Group Inc. The research shows that over time, overweighting companies with favorable prices, profitability, size or momentum can lead to better overall risk-adjusted returns. The key to that, though, is time. Over the long run, these factors should come out on top, but they don't offer any magic to ward off events such as the financial crash or periodic bouts of underperformance, researchers contend. Despite that, advisers in particular seem to be buying into factor investing in a big way this year. To see how the demand for factor investing has popped this year, there is no need to look much further than DFA, which was the first company to focus on factors, sold primarily through advisers. DFA had $11 billion in inflows through the first half this year, more than any other of the 10 largest mutual fund companies except for Pacific Investment Management Co. LLC and Vanguard, according to Morningstar. At Schwab, advisers are also beginning to embrace fundamentally weighted ETFs, which offer a different flavor of value investing. Almost three of five advisers on Schwab's platform reported using fundamentally weighted ETFs, according to the company's Independent Advisor Outlook Study. One in five plans to increase their use of fundamentally weighted ETFs in the near future, according to the study. “The reality is, factor strategies are an active body of work that's happening in the world of academia and the industry,” said Mark Carver, investment strategist at iShares. “We're always trying to find new ways to enhance how we invest for clients. Factors do that,” Mr. Carver said. It isn't just advisers who are open to new ideas. DFA is tinkering with its investment strategy, thanks to new research that made it possible to screen reliably for profitability. This year, it is in the process of including a quality screen to go along with its value and size factors. Much like with passive investing, fees play a big role in determining how well a factor strategy will perform over the long run, Mr. Lee said. “If you're going to do factor investing, you can't pay active-manager fees,” he said. The average DFA U.S. equity fund has an expense ratio of 33 basis points, according to Morningstar. That is about one-third the price of the average equity fund at American Funds, which runs only actively managed funds. The FlexShares Morningstar U.S. Market Factors Tilt ETF (TILT), which leans its portfolio toward small and value companies, charges 27 basis points, while three Schwab Fundamental U.S. ETFs launched last Thursday will charge 32 basis points. The iShares suite of four factor ETFs, which cover size, value, momentum and quality, are the cheapest, with expenses of just 15 basis points. So far, the ETFs are off to a good start in terms of competing. The FlexShares ETF, for example, had a return of 28.15% over the one-year period through Aug. 9. The DFA U.S. Core Fund (DFEOX) had a return of 28.9% over the same time period, according to Morningstar Inc. Both have outperformed the S&P 500's 23% return.