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Factor Investing Goes International

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Factor Investing Goes International

Factor-based investing has demonstrated its ability to create new opportunities for U.S. investors by identifying and over-weighting certain elements in the stock selection process for the indexes underlying exchange-traded funds (ETFs). These elements have included everything from dividends and “quality” to value and momentum.

Many of these factors are now starting to head abroad, and are turning up in the construction process for global and international ETFs.

Do they travel well?

Of course it depends on the factor, but as a general matter we think yes. In fact, in some instances international markets may be less efficient than those in the U.S., creating a dislocation in prices that can be exploited more efficiently by a factor-based approach.

In one such case, we’re applying these ideas to the index underlying the IQ 500 International ETF (IQIN), which uses a rules-based methodology incorporating three fundamental factors: sales, market share, and operating margin.

Based on this selection criteria, we then identify and include the top 500 large cap international companies in the index, based on their composite rank. The fund is diversified by country and sector and is meant to serve as a core international holding.

Of course there are now hundreds of factor-based ETFs out there, using all kinds of rules to build portfolios. So why focus on these three factors? First, we wanted to find something other than market capitalization to define “size.” Big is fine, but it doesn’t tell you much about a company’s profitability or growth prospects. A lot of big companies are just treading water. Sales growth (measured annually), on the other hand, suggests a company that’s succeeding in the marketplace or at least participating in a market that’s seeing an increase in demand. Market share (also measured annually) is a more relative concept; a company with growing share is generally performing well compared to its peers. Finally, operating margin (measured over three years) goes to the company’s ability to grow and take market share while remaining profitable.

Related: Building the Case for Small Caps

By combining these factors in the index underlying IQIN we believe we’re able to identify companies that, collectively, will outperform a similar group of 500 international equities ranked by more traditional measures like market capitalization. Because these companies are spread across multiple industries and sectors it can get a little complicated. There are, in some cases, different regulatory requirements and countries that are at various stages of the economic cycle, but this can generally be accounted for in the construction of the index.

More broadly, we think most investors should have some exposure to international markets. Using a multi-factor tilt to identify and invest in a diversified portfolio of non-U.S. companies that are growing faster, taking market share, and generating cash flow is a good way to start.

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