Factor-Based (Smart-Beta) ETFs: How They Work, Selection Criteria, and Practical Uses for Singapore Investors September 30, 2025

Summary

Factor-based (often called smart-beta) ETFs use transparent, rule-based indexes to tilt exposure toward specific investment attributes (factors) such as value, quality, momentum, dividend yield, growth, or low volatility.

They offer a middle ground between purely passive market-cap indexing and fully active management, adapting ETF mechanisms with a systematic, repeatable focus or priority aimed at improving risk-adjusted returns or reducing volatility.

Examples include dividend or quality ETFs in Singapore (e.g., high-yield Singapore ETFs such as Phillip Sing Income ETF (OVQ)) and US factor ETFs like iShares MSCI USA Momentum Factor ETF (MTUM) and VanEck MSCI International Value ETF (VLUE).

1. What is a Factor-Based ETF?

Simple Definition

A factor ETF tracks an index that explicitly selects and weights stocks according to one or more measurable characteristics or “factors” — e.g., companies with high dividend yields, superior profitability, or recent price momentum.

Why “Smart-Beta”?

The term smart-beta highlights that these ETFs use “smarter” index construction rules than simple market-cap weighting. They are still index-based (rule-driven), providing transparency and low operational subjectivity, but differ from a plain traditional index by seeking outcomes such as higher income, lower volatility, or exposure to value/growth dynamics.

2. Common Factors and What They Capture

Core Factors for Consideration

• Value: Stocks that appear cheap on metrics like price-to-earnings or price-to-book.

o Favours cyclicals, financials at times.

• Growth: Companies with strong sales/earnings growth expectations.

o Favours tech and disruptive firms.

• Momentum: Stocks that have performed well recently (trend-following).

o Can capture strong performers but may reverse in mean-reverting markets.

• Quality: Firms with stable earnings, high returns on equity, low leverage.

o Typically less volatile in downturns.

• Dividend / Income: Companies with higher or growing dividends.

oAttractive for yield seekers and income investors.

• Low Volatility: Stocks with lower historical price swings.

oUseful for defensive allocations.

• Size: Small-cap tilt.

Factor Behaviour

It is important to understand how each factor behaves differently across cycles.

For example, value often outperforms after a market trough or rotation, momentum performs well in trending markets, and low-volatility may protect capital in downturns.

Investors can use factor diversification by combining different factor exposures to smooth returns.

3. How Factor Indexes Are Constructed & Reviewed

Selection & Scoring

• Universe: Start with a market universe (e.g., S&P 500 or Singapore stocks).
• Scoring: Each stock receives a score based on factor metrics (e.g., yield, ROE, price momentum).
• Ranking & Cut-Off: Stocks are ranked; the top N (quantity) or top X% (percentage) are included.
• Weighting: Stocks can be equally weighted, factor-weighted, or follow a modified market-cap rule.

Rebalancing Schedule

Most factor indexes rebalance on a scheduled basis (quarterly, semi-annually). This maintains the factor tilt but creates potentially higher turnover compared to passive traditional indexes. Higher turnover can increase transaction costs and taxable events (for taxable accounts), leading to a higher expense ratio due to the operating cost of rebalancing. Thus, investors should check rebalancing frequency and expected impact of ETF expense ratios.

Example: Income / Quality Index (Singapore)

• Method: Rank by dividend yield, financial health and business quality; pick top 30 names.
• Result: A high-income, quality-tilted basket (e.g., Phillip SING Income ETF methodology).

4. Differences Between Factor Selection vs Traditional Index Selection

Traditional Market-Cap Index

• Selection: All eligible stocks included; weight proportional to market capitalization.
• Outcome: Emphasises largest companies; automatically increases weight as a stock’s price rises (momentum bias).

Factor Index

• Selection: Stocks selected by factor scores (value, dividend, quality).
• Outcome: Overweights companies with desired traits even if they are not the biggest by market cap; can intentionally underweight or exclude certain sectors.

Practical Consequence

Factor indices purposely deviate from market-cap benchmarks to pursue specific performance characteristics — this is why their returns can diverge significantly from plain indices.

5. Factor ETFs: Practical Uses and Examples

Uses in a Portfolio

• Return enhancement: E.g., value or momentum factor for potential excess returns.
• Risk management: Low-volatility or quality factors to reduce drawdowns.
• Income solutions: Dividend factor ETFs for yield-focused allocations.
• Diversification: Combining factors with market-cap exposure to potentially smooth returns across cycles.

Examples (US & Singapore)

• Momentum (US): : MTUM — momentum tilt.
• Value (US): VLUE — value tilt.
• Dividend (US):: VYM or SDY — dividend-focused indices.
• Singapore Income / Quality (SGX): Phillip SING Income ETF (OVQ) — high income + quality selection.
• Thematic overlaps: Growth/AI exposures can be achieved via growth factor ETFs or through thematic ETFs that incorporate factor rules.

Source: S&P Dow Jones Indices. As at 30 September 2024. Based on S&P 500 Index and relevant factor indices. Past performance is not indicative of future returns. You cannot invest directly in an index. Index performance does not take into account any ETF fees and costs.

6. What to Look for When Selecting Factor ETFs

Key Selection Criteria

1. Clear methodology: Read the index rulebook—how are factors measured and weights assigned?
2. Rebalancing frequency and turnover: Higher turnover means higher trading costs and potential tax implications.
3. Historical factor behaviour: Understand cycle sensitivity (e.g., value vs. growth).
4. Fees: Factor ETFs generally cost more than plain market-cap ETFs but less than fully active funds. Compare expected net-of-fee outcomes.
5. Liquidity & AUM: Sufficient assets under management and trading volume reduce bid/ask spreads and tracking uncertainty.
6. Overlap: Check overlap with existing holdings—factor ETFs can unintentionally concentrate similar stocks across multiple funds.

7. Key Takeaways — Factor ETFs

Key Selection Criteria

1. Smart-beta blends rules and targeting: Factor ETFs offer targeted tilts while preserving index transparency and systematic discipline.
2. Know the factor: Different factors perform in different environments; combine factors to diversify factor risk.
3. Mind the mechanics: Rebalancing frequency, turnover, and fees materially affect outcomes—read the methodology..
4. Use factors strategically:Consider factors as building blocks — e.g., combine a core market-cap ETF with a dividend factor ETF and a quality ETF for balanced exposure.

Call to Action

Consider adding selected factor ETFs to your watchlist and reviewing how they perform to observe if any can play a role in your investment portfolio.

Some examples mentioned in this article are:

• OVQ (SGX — Singapore income/quality)
• MTUM (US — momentum)
• Mind the mechanics Rebalancing frequency, turnover, and fees materially affect outcomes—read the methodology..
• VLUE (US — value)
• VYM / SDY (US — dividend focus)

As always, align your ETF picks with your preferred investment goals and strategy. Review choices based on total portfolio exposure to avoid unintentionally becoming overexposed to one or a few counters..

Stay tuned for our next feature, where we explore different aspects of ETF categories in greater detail.