David Blitz has recently discussed the concern in some quarters that factor premiums may disappear as they are arbitraged away by exchange-traded funds.
Blitz, the head of quantitative equity research at Robeco Asset Management, says that such a concern is not justified, because “the exposures of ETFs that may be suitable for factor investors are almost perfectly offset by opposing exposures of other ETFs.”
Blitz’ study focused on the factor exposures of U.S. equity ETFs. His sample included every ETF listed in the U.S. that invests in U.S. equities and that had at least thirty-six months of return history by the close of 2015. There are 415 such funds, and their combined assets under management exceed $1.2 trillion, which is about 5% of the entire U.S. equity market.
Blitz worked from the market excess return of these ETFs, which he defines as the total return minus the risk-free return. He then regressed the time-series of monthly excess total returns for each ETF against the four mainstream factors: size, value, momentum, and low-versus-high volatility.
Of course an ETF can be either long or short on either of these factors. If ETFs as a whole were shorting a factor, it would have the effect of exacerbating the significance thereof, or increasing the excess return available for anyone going long. On the other hand, if the ETFs as a whole were long a factor, that would have the effect of reducing the excess return for anyone else. It would constitute (to some degree) a matter of arbing away the market inefficiency that the factor represents.
By way of review:
The size factor is the excess to be gained by buying stocks with relatively low market capitalization; the value factor is the excess to be gained from stocks that have a low price relative to their underlying value, whether the latter is defined by book value, earnings, dividends, or free cash flow; the momentum factor is the excess to be gained from stocks that have outperformed in the near-term past (three months to one year); and the volatility factor is the excess to be gained from stocks with, well … low vol.