Best Positioning with Factor-Specific ETFs

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As investors craft a portfolio for the current market environment, some may turn to factor-specific ETFs to target themes that could pop up ahead.

For instance, the quality factor has been a prominent investment theme that has outperformed over the years, and it may continue to do so.

"This factor has been outperforming the broad market, to a lesser degree, for the past 10 years," OppenheimerFund's David Mazza and Sam O'Connell wrote in a research note. "The underlying reasons for this outperformance offers insight into what constitutes quality today, and they also provide an indication of where investors looking to incorporate factor tilts into their portfolios may want to add exposure."

Investors usually gain exposure to quality through defined metric such as corporate profitability, operational efficiency, earnings quality, and financial leverage.

Last year, the quality factor outperformed the broader market by 638 basis points, which was surprising as the year was dominated by growth names and the factor has been associated with outperformance in periods of economic slowdowns.

However, the quality factor index now includes a healthy dose of information technology names, which may have contributed to the outperformance of the factor in 2017. While many think of information technolgoy as a traditional growth sector, these same companies have recently offered a high return on equity, strong profit margins, and low debt-to-equity ratios, which are all quality traits.

Consequently, the quality and momentum factors may be more correlated in recent years.

"It may surprise investors that the quality factor has become highly correlated to the momentum factor, given that, historically, this has not often been the case. The momentum factor isolates on stocks that have delivered recent winning performance, especially relative to other stocks that may have recently posted lackluster or negative returns. With quality stocks having performed so well over the past few years, they have become some of the market's momentum stocks," the Oppenheimer strategists said.

Investors interested in riding on the ongoing strength in the quality segment may turn to factor-specific ETF plays, such as the Oppenheimer Russell 1000 Quality Factor ETF (OQAL), which bets on higher quality companies in the hopes that they perform better than lower-quality companies.

Additionally, investors are not limited to only selecting one market factor when building a diversified investment portfolio.

"By analyzing each factor’s current fundamental makeup, in addition to its long-term risk and return profiles, we can gain well-rounded insights into the expected investment outcome that any combination of factors in a portfolio might deliver," the strategists said. "For those looking to employ a strategy that blends factors, today a tilt toward a pro-cyclical factor such as value combined with the momentum factor could potentially offer the flexibility to both participate in an expansionary market and maintain defensive characteristics."

For example, an investor may consider something like the Oppenheimer Russell 1000 Value Factor ETF (OVLU) that plays on the theme of stocks that appear cheap tend to perform better than stocks that appear expensive. Additionally, one may combine it with the Oppenheimer Russell 1000 Momentum Factor ETF (OMOM), which follows the idea that stocks which rise or fall in price tend to continue rising or falling in price.

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