Andrew’s Angle

Keep more of what you earn

Nov 30, 2020

The capacity of factor strategies appears large 

There’s a famous adage by Benjamin Franklin that “in this world nothing can said to be certain, except death and taxes.”

With the utmost respect to Franklin, in the world of investment management this is not quite right. Market outcomes are uncertain, like whether over a short time period equities can outperform bonds, or whether in a given quarter one factor, like momentum, beats another factor, like value (as previously written here). But there are two certain things in investment management: that, all else equal, reducing fees and lowering taxes, can improve outcomes for investors.

Lowering expenses

There are four primary drivers of returns for fund managers: market returns (or beta), static tilts to broad and persistent factors, time-varying factor positions, and finally security selection. The first two of these return components can sometimes be delivered in more transparent, lower cost forms—often in market-cap index and factor  ETFs.

In a recent paper, I analyzed 1,312 US active equity mutual funds, with AUM of $3.9 trillion, over the five-year period ending June 30th, 2019.1 The mean active return (fund return minus benchmark) was -1.2% per year. In fact, only for the top 10% of funds has security selection added positive returns delivering true, differentiated alpha.

Another component of returns, static factor exposures, resulted in negative returns for 50% of these active funds – because, on average, these managers held opposite factor exposures to those that have been rewarded over the long run (for example, funds with negative quality exposure instead of positive quality exposure detracting from long-run returns). Even for those funds with positive factor exposures, there may be an opportunity to improve upon their returns by replacing underperforming active managers with factor ETFs.

Components of Active Returns

Chart: Components of Active Returns

Source: BlackRock, based on Morningstar data. Return attribution is for 5-year period from 6/30/14 – 6/30/19 using quarterly holdings. Figures represent the mean components of excess return, grouped by deciles of active return across the MorningStar Style Box categories. Funds are grouped together at the master share class level to avoid double counting. Here, active returns are fund returns in excess of prospectus benchmark and net of fees. Indexes are unmanaged and cannot be invested into directly. Figures are means by decile of active return. Past performance does not guarantee future results.

The average US Large Cap active fund is more than four times more expensive than the average iShares US Factor ETFs in the same category! The table below shows that the average expense ratio for US Large Cap active funds is 67bps compared with 15bps for iShares US Factor ETFs. With Factor ETFs, you can more directly control your exposure to these rewarded drivers of return as well as potentially improve your outcome by decreasing expense ratios.

Chart: Average Expense Ratios

Source: Morningstar and BlackRock as of 6/30/2020. Comparison is between the prospectus net expense ratio for the oldest share class of active U.S. mutual funds and iShares ETFs within the respective category. Morningstar categories for large cap active U.S. mutual funds include U.S. Equity Large Cap Blend, U.S. Equity Large Cap Value and U.S. Equity Large Cap Growth. iShares ETFs used to represent the average expense ratio are VLUE, QUAL, MTUM, SIZE and USMV..

Managing taxes

One solution that can help investors control costs through managing taxes:  tax-efficient ETFs.

My colleague Michael Lane recently wrote about Reducing the tax bite by implementing ETFs in your portfolio. One of the striking points in his post is how significant tax drag can be on the returns for an individual’s portfolio. In many cases it has a bigger impact than the explicit expense ratios of the funds themselves. In the US Large Cap fund category, the average tax cost over the 10 years ending in December 2019 was 1.77%. As you can see below, the compounding effect of what may seem like a small percentage adds up to a meaningful dollar amount over the years.

Tax drag lowers returns

Chart: Tax Drags Lower Returns

Source: Morningstar as of Dec. 31, 2019. Tax Cost measures how much a fund's annualized return is reduced by the taxes investors pay on distributions (Difference between total annualized pre- and post-tax returns over 10 years.) Data calculated using the oldest share class of all Active US large cap Equity Open-End Mutual Funds available in the U.S. Source: BlackRock. The chart is for illustrative purposes only and is not indicative of the performance of any actual fund or investment portfolio. Does not include commissions or sales charges or fees. 12% represents the average pre-tax return over the same 10-year period for large cap equity mutual funds (12.08%). The hypothetical growth of $100,000 over ten years at an 12% return is $310,584.82. The hypothetical growth over ten years at an 12% return with a 1.77% tax cost is $264,848.84, resulting in a tax cost of $45,735.98.

ETFs not only typically cost a fraction of a typical actively managed mutual fund, but where ETFs can really punch above their weight is in their tax efficiency. Although they represent 19% of managed assets, they distributed less that 1% of 2019’s total capital gains distributions, helping clients keep more of what they earned. iShares US Factor ETFs have never paid a pass-through capital gain since their inception.2

One common myth is that high turnover often leads to more capital gains distributions for both ETFs and mutual funds. This is not true! A shining example of how Factor ETFs can deliver some of the benefits of tradional actively managed mutual funds, while maintaining their tax efficiency is the iShares MSCI USA Momentum Factor ETF.  Although high turnover can lead to additional capital gains being distributed to investors—especially for mutual funds, the ETF wrapper helps mitigate these consequences. The iShares MSCI USA Momentum Factor ETF has averaged 119% turnover per annum since its first full year in 2014 and since inception has not distributed any capital gains to its investors.3 Further information on why the ETF wrapper is more efficient can be found here.

The certain certainties

Each incremental source of return is important. Since there are components of our returns that we can’t control, it’s imperative we take advantage of those we can. In this world of uncertainty, take control of your expenses and manage your taxes through the implementation of Factor ETFs—helping you keep more of what you earn.


Andrew Ang, PhD
Andrew Ang, PhD
Head of Factors, Sustainable and Solutions for BlackRock Systematic
Andrew Ang, PhD, Managing Director, is Head of Factors, Sustainable and Solutions for BlackRock Systematic. He also serves as Senior Advisor to BlackRock Retirement ...
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