Factor-based investing goes international

by: , Chief Investment Officer and Managing Director | IndexIQ

Factor-based investing can add value to a portfolio, when the factors are carefully selected and properly weighted. That’s been demonstrated domestically, first with equities and more recently in fixed income (momentum, for example). These same ideas are starting to be applied internationally as well.

While there are hundreds of factor-based ETFs focusing on the U.S. market, targeting everything from dividends to volatility, it’s still early days overseas. As global and international factor-based funds start to be introduced, the question for investors is: will the process work, and will it work in the same way, in non-U.S. markets? In our view, the answer to the first question is clearly yes, though not every factor will add value or deliver results for investors.

As to the second, we think the process of identifying and applying factors will require taking into consideration the characteristics of local markets and companies, as well as the interaction among sectors, countries, and regions. There will be some factors that may work well in the U.S. but less well outside, and vice versa.

Based on this, we identified three initial factors that we believe provide the foundation for a well-diversified, core international equity portfolio: sales, market share, and operating margin.

In practical terms, these factors orient a portfolio toward mature companies with strong market positions that are operating efficiently—generally attractive investment qualities. They are designed to result in a portfolio that’s more diversified, and with the potential to generate better risk-adjusted returns. As part of the research process, we ran the numbers, examining the historical returns dating back to December 31, 2007 for the IQ 500 International Index, and found that these factors, as expected, did add value for the time period under consideration.

In contrast to this factor-weighted portfolio, most international stock funds are market-cap-weighted. This tends to skew the holdings towards larger-cap stocks, resulting in a more concentrated portfolio, without necessarily distinguishing those companies with the potential to outperform their peers. These characteristics can result in a significant drag on a portfolio when a fund’s constituents suffer from price deviation from their fundamental values. By using a fundamental factor approach, the portfolio construction decouples from price, while still taking advantage of favorable, fundamental metrics.

The case for investing internationally is well established by now—access to more rapidly growing markets (in some cases), access to countries and regions at different points in the economic cycle, improved overall portfolio diversification, and more. In considering whether a factor-based approach is the best way to go about this, U.S.-based investors have the benefit of several years of exposure to factor-based funds to help with the decision-making process.

Our work supports the case that factor-based, fundamentally-driven security selection can allow for improved country diversification and sector weightings compared with a market-cap-weighted index with a large-cap focus. An index based on these principles can provide a solid vehicle for establishing a core position in markets outside the U.S.

About risk

The IQ 500 International Index selects and weights securities utilizing a rules-based methodology incorporating three fundamental factors: sales, market share, and operating margin. The top 500 international securities, based on their composite rank, are included in the index.

Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value. An investment cannot be made in an index.

This material represents an assessment of the market environment as of a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities, or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.

This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances, and consideration should be given to talking to a financial advisor before making an investment decision.

New York Life Investments is a service mark and name under which New York Life Investment Management LLC does business. New York Life Investments, an indirect subsidiary of New York Life Insurance Company, located at 51 Madison Avenue, New York, NY 10010, provides investment advisory products and services. IndexIQ® is an indirect, wholly-owned subsidiary of New York Life Investment Management Holdings LLC and serves as the advisor to the IndexIQ ETFs. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.

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Salvatore J. Bruno

Chief Investment Officer and Managing Director | IndexIQ

Sal is Chief Investment Officer at IndexIQ, where his primary responsibility includes developing and maintaining the firm’s investment strategies. Sal joined IndexIQ in 2007 from Deutsche Asset Management (DeAM) where he held a number of senior positions

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