Index ETFs have evolved beyond merely providing passive exposure to the market, with a new generation of factor ETFs utilizing complex rules-based methodologies to beat benchmarks.
Investors are increasingly looking to ETFs as they search for ways to help enhance performance and streamline tax efficiency compared to mutual funds. However, investors looking at familiar, broad indexes may be missing out on performance.
“Broad indexes originally were not designed to be investable products. They were designed to measure performance – not maximize it. What we are seeing is that there are opportunities to improve upon these indexes,” Michael Mack, client portfolio manager for Victory Capital, said at Exchange.
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According to Mack, some equity active managers examine opportunities through the lens of free cash flow (FCF) and other factors. Conversely, indexes have used stocks as data. There may be 150 years of data and academic research on price-to-book ratios. However, in 2025, those constructing new indexes might want to look more towards the bottom line of something like FCF instead, Mack said.
“That’s the opportunity we are seeing with indexes, the ability to evolve them,” Mack said. “Take an idea that an active manager would actually implement. Put it in a rules-based index, and take advantage of the ETF structure and the tax efficiency that comes with that.”
What Sets the New Generation of Factor ETFs Apart From the Benchmark
Looking at traditional value indexes, such as the Russell 1000 Value Index, there are other considerations like valuations.
“The Russell 1000 Value Index is trading at 15 times earnings. If you can get a true value exposure at 10- or 11-times earnings, potentially, you’ve diversified your risk,” Mack explained. “It’s important to be mindful of a portfolio’s P/E ratio, particularly in the current environment. Economic shock can’t be controlled, but valuation may be controlled to reduce risk.
In an environment like the early 2000s, and 2022, sitting at 10 times to 12 times earnings is better than sitting at 18 times [earnings] making it very important.”
Active Management Is Gaining Traction, But Factor ETFs Offer Different Potential Benefits
With active ETFs gaining in popularity in recent years, investors may wonder what advantage factor ETFs may have over an actively managed approach.
A key potential benefit to a factor ETF that tracks an index is that it is a transparent, repeatable process. The same rules-based methodology can be used for back testing the index. Advisors know that the ETF will be managed consistently with the index. With active management, there are other variables, Mack said.
“With the consistency of a rules-based strategy, you should know what you’re getting,” Mack said. “The rules that generated the back test are the same rules that will be applied going forward. That consistency of the process makes the due diligence process a lot easier for our clients.”
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