Investing in an S&P 500 index fund will provide “market” returns, but it won’t necessarily provide a diversified portfolio. Apple, Nvidia and Microsoft account for 13% of the total, and the top 26 stocks represent about half! While these companies have done well in recent years, the portfolio concentration makes investors susceptible to a tech downturn.
Equal-weight funds provide even diversification across every index component — but sometimes, you want more exposure to growth or value. While actively managed funds and ETFs can help build customized portfolios, you’re relying on a fund manager’s decisions, and higher fees can eat into your returns over time.
Factor ETFs offer a unique solution to these challenges. Unlike actively managed funds, they cost-effectively build and track an index using predefined criteria ranging from price-earnings ratios to dividend yields. Being typical passive index funds, they let you customize your exposure based on more “factors” than just market capitalization.
Let’s take a closer look at these funds and whether you should consider them for your portfolio in today’s highly concentrated markets.
What Are Factor ETFs?
Factor ETFs build a portfolio based on the characteristics of a stock instead of its market capitalization. For instance, a value-focused factor ETF may look at price-earnings or price-book ratios and invest more assets in undervalued companies. As a result, it’s easier to customize exposure based on market conditions and minimize concentration risks.
The most common factors include:
- Size: Smaller companies historically outperform larger ones due to greater growth potential and higher risk. Investors seeking higher potential returns and willing to accept more volatility might consider factor ETFs targeting small-cap stocks.
- Value: Companies trading at lower multiples relative to fundamentals, like earnings or cash flow, tend to outperform growth stocks over long periods. Contrarians looking to capitalize on market inefficiencies and mean reversion may consider value-focused factor ETFs for their portfolio.
- Yield: High-dividend stocks often indicate stable, mature companies with strong cash flows. In addition to the appeal for income investors, dividend-paying companies historically have lower volatility and better downside protection, which may appeal to investors looking for stable returns.
- Low Volatility: Stocks with smaller price swings tend to deliver better risk-adjusted returns than highly volatile securities. So, conservative investors seeking market participation with less drawdown risk may prefer these strategies.
- Momentum: Stocks showing positive price trends often continue their trajectory due to market sentiment or underlying business growth. While these portfolios may have more concentration, they may be ideal for growth-oriented investors.
Rather than investing in a broad market capitalization-weighted index, factor ETFs open the door to investing in specific strategies. Investors looking for lower risk, higher yields or a value-oriented approach to the market may prefer this over the S&P 500 — especially because the costs are lower than many active mutual funds and ETFs.
Most Popular Factor ETFs
Factor ETFs have had a hot and cold relationship with investors over the past several years. In 2023, analysts questioned whether many factor ETFs would stick around following muted inflows. However, in 2024, factor ETFs took in around $50 billion in net inflows, suggesting that investor appetite remains.
Popular Factor ETFs
These funds are sorted by their 1-year total return, which ranges from 9.8% to 35%. They have AUM between $430M and $25B, with expenses between 0.13% and 0.25%. They are currently yielding between 1.4% and 2.1%.
| Name | Ticker | Type | Active? | AUM | 1-year Total Ret (%) | Yield | Expense |
|---|---|---|---|---|---|---|---|
| iShares MSCI USA Momentum Factor ETF | MTUM | ETF | No | $13.9B | 34.7% | 1.4% | 0.15% |
| Vanguard U.S. Quality Factor ETF | VFQY | ETF | Yes | $438M | 17.2% | 1.5% | 0.13% |
| iShares MSCI USA Min Vol Factor ETF | USMV | ETF | No | $24.3B | 14.7% | 1.9% | 0.15% |
| Invesco S&P 500 Low Volatility ETF | SPLV | ETF | No | $7.81B | 11.4% | 1.7% | 0.25% |
| iShares Russell 2000 Value ETF | IWN | ETF | No | $13.9B | 9.8% | 2.1% | 0.24% |
Not surprisingly, momentum-focused factor ETFs experienced the best performance in 2024 thanks to the meteoric rise of companies like Nvidia (NVDA). Meanwhile, dividend and value-focused factor ETFs underperformed the “market” since they don’t hold high-flying stocks that drove the S&P 500 index sharply higher.
Do Factor ETFs Outperform?
Factor ETFs employ many strategies to try and outperform the market. While there’s no shortage of academic literature supporting various factors, critics point out that the results aren’t always reliable. Others insist that many academic studies lack statistical significance, suggesting the findings may be chalked to noise.
However, there are other explanations for long-term outperformance, too.
Smaller or undervalued companies may be higher risk, which means higher returns are necessary to compensate for that risk. On the other hand, investors piling into highly volatile stocks could leave less capital available to invest in low-volatility companies, resulting in a comparatively cheaper share price.
And, of course, factor funds don’t always outperform during the short run.
Value stocks typically underperform during bull markets when momentum stocks see the biggest gains. At the same time, some factors may have higher concentration risk than others. For instance, a yield-focused strategy may have a high concentration of stocks in real estate, energy, and other higher-yielding industries.
One solution to these challenges is rotating factors depending on the economic cycle. And that’s exactly why many investors piled into the iShares US Equity Factor Rotation ETF (DYNF) last year. The fund is up more than 30% over the past 52 weeks compared to the 24% gain in the S&P 500 index over the same timeframe.
The Bottom Line
The growing concentration risk in the S&P 500 could make factor ETFs a compelling way to diversify your portfolio. Rather than overpaying for a conventional active ETF or investing indiscriminately with an equal-weight fund, investors may want to consider factor ETFs — or even factor rotation strategies — to customize their exposure based on their requirements and the broader economic cycle.
