Content provided by CLS Chief Strategist Scott Kubie.

“And the Miami Dolphins, with the eighth pick in the 2012 NFL draft, select Ryan Tannehill from Texas A&M.” Tannehill’s high selection in the 2012 draft was controversial. He only started 19 games in college, spending more games catching passes than throwing them. Statistically, he ranked 56th in quarterback rating for the 2011 season.

Tannehill’s selection, while controversial, has some interesting parallels to ETFs using quantitative models to target a particular set of factors. Factor ETFs generally seek to adjust the mix or weights of the securities in an index, based on one or more measure, to improve the return or the general risk-reward potential of the portfolio. Existing factor ETFs emphasizes include quality, value, momentum, low volatility, and dividends. For football fans, the following bullet points may help explain factor ETFs in more familiar terms:

1. Factor ETFs look at non-traditional statistics

The college quarterback with the third highest rating in 2011, Kellen Moore, provides an interesting contrast to Tannehill. He easily bested Tannehill in completion percentage, touchdowns, and interceptions. Yet Moore was undrafted because he didn’t perform well on two non-traditional evaluation measures, height and arm strength.  Moore is about 6’0” tall while Tannehill is nearly 6’4”. Traditional statistics used by investors include sales, margins, or earnings per share. Factor investors often look at different statistics than traditional investors. Characteristics like quality and low volatility aren’t the favorite statistics of most bottom-up stock pickers, but are popular, not-traditional factors.

2. Factors require some fortitude

Teams that use this approach are willing to fail unconventionally. A bad draft pick is fodder for sports radio shows. People still make Ryan Leaf jokes and he was drafted in 1998. There are going to be periods where factor approaches lag the market, sometimes for years. The value of a factor approach is realized overtime, but not every year. Factor investors are patient and trust the long-term results.

3. Factors use large numbers of securities to manage risk

Professional football teams should apply this approach for every pick, every year. Without consistent application the approach can’t be evaluated. Many factor ETFs are well diversified because they focus on a few key factors and hold many different securities, diluting the individual risk from a single bad pick.

4. Factors are vulnerable to overuse

When too many teams switch their approaches and put emphasis on the same factors, the competitive advantage of the evaluation system declines. Many factor strategies are designed to take advantage of an investor bias. As factor strategies become more popular it will be incumbent on investors to make sure the factor hasn’t become mainstream.

At CLS, we keep these facts in mind. While we continue to increase our use of factor strategies, we realize not all of them will work all the time. We stay diversified and emphasize the most attractive strategies rather than using all of them. For the Dolphins, Tannehill has worked out okay. He’s started every game the last two years and last season the Dolphins narrowly missed the playoffs.

But, CLS continues to use traditional approaches as well. The NFL shows that traditional approaches can pay high value. The highest rated college passer in 2011 was a 5’11” quarterback who switched schools his senior year and seemed more interested in playing baseball. He was finally drafted with the twelfth pick in the third round. His name was Russell Wilson. In his first season he was named the Rookie of the Year and the following year he won the Super Bowl.

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An ETF is a type of investment company whose investment objective is to achieve the same return as a particular market or commodity index, or a basket of assets. An ETF is similar to an index fund in that it will primarily invest in the securities of companies that are included in the selected index. An ETF will invest in either all of the securities or a representative sample of the securities included in the index.  While ETFs tend to be lower in cost to other investment companies, such as mutual funds, there are costs that apply.  Always research a particular ETF prior to investing in order to determine its fees.  Diversifiable risks include, but are not limited to business risk, regulatory risk, and capital risk.  A Factor ETF is an Exchange Traded Fund which seeks to reduce market risk by intentionally biasing itself in one or more factors such as size, momentum, value, etc.  While Factor ETFs seek to reduce market risk, such risk can never be eliminated.