Podcast: A Deep Dive on Factor ETFs - June 5, 2024

In this deep-dive episode, special guests Paul Riccardella, Richard Ho, and your host, Kevin Prins, provide a careful analysis of factor ETFs — from their early history to how they are constructed. They also discuss MSCI’s unique methodology and several prudent ways to avoid value traps. 

Kevin Prins is the Managing Director and Head of Distribution for ETFs and Digital Distribution at BMO Global Asset Management. He is joined on the podcast by Paul Riccardella, Executive Director of Client Coverage at MSCI, and Richard Ho, Vice President of ETF Distribution at BMO Global Asset Management. The episode was recorded live on Wednesday, June 5, 2024.

Episode Summary

MSCI the Brand

MSCI is a global public company that is index- and analytics-oriented. MSCI has been around for more than 50 years. There is about $1.6 trillion directly linked to MSCI indexes and another several trillion dollars in institutional separately managed accounts (SMAs) linked to its indexes. MSCI helped create the world’s first multifactor risk model under the brand name Barra. What differentiates MSCI is the flexible nature of its methodology. For example, its indexes are not number locked, so there is not a MSCI USA 500 or 1,000. As well, most of MSCI’s competitors only offer standard large-cap indexes, whereas at MSCI, its most well-known indexes are both large- and mid-cap.

Factors

When the team at BMO Global Asset Management is out in the field speaking to investors and advisors, a lot of discussions right now revolve around the Quality and Value factors. Quality is defined as high return on equity, stable earnings growth, and low financial leverage. BMO ETF’s uses an enhanced value approach for its Value factor, screening for companies with low price-to-book (P/B), price-to-forward earnings (P/E) and enterprise value to cash flow from operations. This is where we are currently seeing demand.

Quality – Index Construction

For MSCI’s Quality indexes, we start with a MSCI parent market cap index, whether it is USA, Canada, EAFE or Emerging Markets. We then apply a screen of return on equity, earnings variability measured by five-year earnings growth, and debt to equity. We equally weight those screens and based on the results we eliminate roughly 70% of the universe. For the remaining 30%, we measure the magnitude of how well each of those stocks scored against those screens and multiply that magnitude by the original market cap of the stock. Quality is a factor that does not require many constraints, so we allow sector and region drift by weight.

Value – Index Construction

Value investing has been a significant field for decades, starting with Graham and Dodd. The MSCI approach, and the method BMO ETFs are based on, is called enhanced value. We screen to eliminate about 70% of the universe and reweight the remaining 30% based on original stock market caps and the magnitude of the value score. The value score is based on P/B, forward P/E, and enterprise value to cash flow on a three-year basis. Based on the three-year time frame and the fact the methodology is sector neutral, this helps to avoid value traps.

Emerging Markets

The major concerns with investing in emerging markets, like India and China, are whether companies are state owned and whether the company has strong corporate governance. As it relates to the partnership with BMO and MSCI on India- and China-specific ETFs, the broad methodology that we offer is sustainability oriented. That means there are additional screens for companies that pass international standards of doing business and are compared against the best governed companies around the world before being included in the index.

Price-to-book value: The ratio of a company’s market cap (or the value of its shares) to its book value.

Forward P/E ratio: The forward price to earnings ratio is the ratio for valuing a company that measures its current share price relative to its forecasted per-share earnings (EPS).