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Factor-Based ETFs vs. Hedge Funds

These ETFs let investors to risk without options or futures.

January 25, 2012

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which way signIt’s a trend that has started small, but has the potential to make some big waves in the investment industry: factor-based ETFs. A handful were launched in recent months, presenting a low-cost option for managing risk factors at a time when concerns about portfolio risk are at all time highs.

Active managers and hedge funds have long relied on a factor-based approach to build their strategies. New ETFs such as those launched by Russell last year focus on specific factors like beta, volatility and momentum.

Factor-based ETFs offer a way for investors to manage risk based on individual securities without having to employ other strategies like options or futures. For institutions that currently use hedge funds to either mitigate or enhance risk in their portfolios, factor-based ETFs could evolve into an interesting alternative – one that allows institutions to take directional bets on where they think the market is headed, without having to pick individual stocks.

The some are asking is whether or not factor-based ETFs could take market share from the hedge fund industry. Probably not right now. But as they gain liquidity and keep costs low, they could provide some serious competition, especially in the cost-conscious pension space.

Factor-based ETFs have also brought attention back to hedge fund replication, an approach that became popular just before the financial crisis, but fell out of favour as hedge fund returns took a hit during tough times.

Along with Russell, other providers have been getting into the factor game — Credit Suisse has launched several more hedge fund replication ETNs and two startups, QuantShares and FactorShares, are also moving into the space.

Whether or not pension funds will bite remains to be seen – but it’s a compelling approach that they should at least consider moving forward.

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