By Holly Framsted, Head of US Factor ETFs within BlackRock’s ETF and Index Investment Group.

Holly Framsted, Head of US Factor ETFs within BlackRock’s ETF and Index Investment Group.

Investors have flocked to single-factor ETFs with $90 billion inflows over the past ten years. However, when dissecting these flows further, one can’t help but notice that US factor ETFs have captured the majority of flows and investor adoption of international factor ETFs has lagged.

While investors have embraced both US single factors and broad international markets, they have been slower to adopt international single factor ETFs despite international single factors offering the potential for return enhancement or risk reduction. Are investors missing an opportunity to pursue the potential benefits of factors in their international allocations? We would argue yes.

The role and use of factors in a portfolio shouldn’t stop with US equity. Factors have been the long-term drivers of investment returns; their benefits and behaviors have persisted not only in US markets but also in non-US markets.

As a result, much like how factors are used in a US equity allocation, factors can also be deployed in international markets to seek enhanced returns or reduced risk. Not unexpectedly, international single factors have retained similar return and risk characteristics to their US counterparts allowing investors familiar with US factors to easily extend their use of factors to international markets. To illustrate, we evaluate the historical behavior of three single factors – quality, momentum, and minimum volatility.

Using factors to beat the market

Certain style factors such as quality and momentum can be deployed with the goal of enhancing return relative to the broader market. In the graph below, we examine the performance of these potential return-enhancing single factors in both US and international markets.

As expected, US quality and momentum have outperformed the broader US market over time.  However, does this return-enhancing behavior of the quality and momentum factors hold in international markets?

Indeed, the outperformance of quality and momentum factors has persisted in international markets over time. In fact, from January 2015 through June 2019, the international quality and momentum factors have outperformed the broader market by an average of 1.6% and 1.1% per year, respectively. As a result, investors may consider deploying factors within their international allocations in seeking above-market returns.

Source: BlackRock.

Using factors to reduce risk

However, what if the investor’s primary objective is not to enhance return, but rather to reduce risk in their portfolio while still remaining invested in the market? A minimum volatility strategy may be appropriate. Within the US, minimum volatility has historically delivered lower risk than the broader market as observed in the graph below.

Notably, we also observe that this demonstrated behavior of lower risk compared to the broader market also persists in international markets. In fact, from February 2012 through June 2019, international minimum volatility has outperformed the broader market by an annualized 2.1% with only 75.6% of the risk. Thus, investors seeking to access international markets with lower risk or desiring to reduce the risk of their existing international allocations may want to consider using a minimum volatility strategy within their portfolios.

Source: BlackRock.

Deploying international factors

In addition to simply using international factors to strategically enhance return or reduce risk over time, factors can also be deployed more tactically. Similar to US single factors, the performance of international single factors has demonstrated cyclicality. Investors can leverage this demonstrated behavior by tilting toward or away from factors based on the economic cycle.

For example, if the economy is headed into a period of slowdown or contraction, investors may want to build resilience into their portfolios and tilt toward quality or minimum volatility, which have tended to perform well in challenging market environments. On the other hand, if the economy is in a period of expansion, tilting toward momentum may be more appropriate.

Source: BlackRock.

Conclusion

Factors – quality, momentum, low size, value, and minimum volatility – are the historical long-term drivers of returns and their characteristics have persisted within and across equity markets. As a result, investors can use factors across the globe both strategically, and tactically, to seek enhanced returns or reduced risk.

The narrative and rationale for both US and international exposures are also consistent, allowing investors’ familiarity with domestic factor investing to extend globally. For these reasons, we believe the prudent investor should consider incorporating the potential benefits of factor investing beyond the US and into their international allocations.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)