Help me understand factor ETFs

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Jake806
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Help me understand factor ETFs

Post by Jake806 » Thu Jul 11, 2019 1:02 am

Hello!

I know there have been a lot of factor investing threads recently, but my question is about how they function.

If a company that’s considered small cap over time develops into a medium cap company, is it automatically sold after passing a certain market cap threshold? If it falls back down into small cap territory is it purchased at the top of the “small cap” range determined by Vanguard or whoever controls the fund? If this were the case there’d obviously be nowhere to go but down, so I don’t think that’s the case. Is the main goal of a small cap index fund to capture the gains of companies’ stocks from the point it becomes large enough to be small cap until it exits small cap range?

These questions also pertain to value index funds. If companies are considered to be cheap enough by certain metrics to be considered value stocks, then once they stop being “cheap” enough are they automatically sold at the top?

Thank you!!

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oldzey
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Re: Help me understand factor ETFs

Post by oldzey » Thu Jul 11, 2019 3:42 pm

Hello Jake806 and with your first post, a warm welcome to the forum!

Best,
oldzey
"The broker said the stock was 'poised to move.' Silly me, I thought he meant up." ― Randy Thurman

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vineviz
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Re: Help me understand factor ETFs

Post by vineviz » Thu Jul 11, 2019 3:54 pm

Jake806 wrote:
Thu Jul 11, 2019 1:02 am
If a company that’s considered small cap over time develops into a medium cap company, is it automatically sold after passing a certain market cap threshold? If it falls back down into small cap territory is it purchased at the top of the “small cap” range determined by Vanguard or whoever controls the fund?
Yes, and yes.
Jake806 wrote:
Thu Jul 11, 2019 1:02 am
Is the main goal of a small cap index fund to capture the gains of companies’ stocks from the point it becomes large enough to be small cap until it exits small cap range?
This might sound circular, but I'd say the main goal of a small cap index fund is to own a representative cross-section of small cap stocks.

There is no explicit expectation that the stocks will become large caps so much as an expectation that some investors want to own small cap stocks.
Jake806 wrote:
Thu Jul 11, 2019 1:02 am
These questions also pertain to value index funds. If companies are considered to be cheap enough by certain metrics to be considered value stocks, then once they stop being “cheap” enough are they automatically sold at the top?
Factor index funds aren't trying to time stocks: a value fund will sell stocks when they stop being cheap enough to be "value stocks". But there is no consideration for whether that might represent the "top" or not. The evidence tells us that in aggregate cheap stocks produce higher returns than expensive stocks, so I guess you could say that implicitly value investors are hoping to own stocks that are more likely to go up than the average stock.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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9-5 Suited
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Re: Help me understand factor ETFs

Post by 9-5 Suited » Thu Jul 11, 2019 3:59 pm

It would be interesting historical perspective (if anyone happens to know the answer!) how many small cap stocks from say 10 years ago:

- No longer exist today
- Remain small cap stocks today
- Are mid cap stocks today
- Are large cap stocks today

My guess would be that a small cap stock becoming a large cap stock is pretty rare, but have never seen any data on that topic.

alex_686
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Re: Help me understand factor ETFs

Post by alex_686 » Thu Jul 11, 2019 4:07 pm

9-5 Suited wrote:
Thu Jul 11, 2019 3:59 pm
It would be interesting historical perspective (if anyone happens to know the answer!) how many small cap stocks from say 10 years ago:

- No longer exist today
- Remain small cap stocks today
- Are mid cap stocks today
- Are large cap stocks today

My guess would be that a small cap stock becoming a large cap stock is pretty rare, but have never seen any data on that topic.
Not sure that would help.

Small caps act different at different times.

Small caps used to outperform large caps as small caps grew into large caps. Not so much anymore. Now they tend to be more value like, kicking off dividends. Or they list as large caps, skipping the small cap stage.

In the 80s there were many cross mergers, or mergers of equals, where the company would remain in the small cap space. Now large caps buy up the small cap companies.

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9-5 Suited
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Re: Help me understand factor ETFs

Post by 9-5 Suited » Thu Jul 11, 2019 4:52 pm

alex_686 wrote:
Thu Jul 11, 2019 4:07 pm
9-5 Suited wrote:
Thu Jul 11, 2019 3:59 pm
It would be interesting historical perspective (if anyone happens to know the answer!) how many small cap stocks from say 10 years ago:

- No longer exist today
- Remain small cap stocks today
- Are mid cap stocks today
- Are large cap stocks today

My guess would be that a small cap stock becoming a large cap stock is pretty rare, but have never seen any data on that topic.
Not sure that would help.

Small caps act different at different times.

Small caps used to outperform large caps as small caps grew into large caps. Not so much anymore. Now they tend to be more value like, kicking off dividends. Or they list as large caps, skipping the small cap stage.

In the 80s there were many cross mergers, or mergers of equals, where the company would remain in the small cap space. Now large caps buy up the small cap companies.
It isn't intended to help anything, I'm just curious how company migration shakes out if someone happens to know of a data source. Yes, there would be a fifth option for "merged with or got bought by another company" that is a sub-set of the "does not exist anymore" bucket.

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Jake806
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Re: Help me understand factor ETFs

Post by Jake806 » Fri Jul 12, 2019 6:09 am

vineviz wrote:
Thu Jul 11, 2019 3:54 pm
Jake806 wrote:
Thu Jul 11, 2019 1:02 am
If a company that’s considered small cap over time develops into a medium cap company, is it automatically sold after passing a certain market cap threshold? If it falls back down into small cap territory is it purchased at the top of the “small cap” range determined by Vanguard or whoever controls the fund?
Yes, and yes.
Jake806 wrote:
Thu Jul 11, 2019 1:02 am
Is the main goal of a small cap index fund to capture the gains of companies’ stocks from the point it becomes large enough to be small cap until it exits small cap range?
This might sound circular, but I'd say the main goal of a small cap index fund is to own a representative cross-section of small cap stocks.

There is no explicit expectation that the stocks will become large caps so much as an expectation that some investors want to own small cap stocks.
Jake806 wrote:
Thu Jul 11, 2019 1:02 am
These questions also pertain to value index funds. If companies are considered to be cheap enough by certain metrics to be considered value stocks, then once they stop being “cheap” enough are they automatically sold at the top?
Factor index funds aren't trying to time stocks: a value fund will sell stocks when they stop being cheap enough to be "value stocks". But there is no consideration for whether that might represent the "top" or not. The evidence tells us that in aggregate cheap stocks produce higher returns than expensive stocks, so I guess you could say that implicitly value investors are hoping to own stocks that are more likely to go up than the average stock.
Thank you all for the responses!

The owning a cross-section of small cap stocks idea makes a lot of sense!
If stocks with a falling market cap would be purchased at the top of the range that is considered small cap, do you know if the stock would be purchased after passing the same threshold as it would be sold going up? If this is the case, it seems as if it would be extremely inefficient as that stock would either lose value further and negatively affect the fund's performance, or immediately be sold if it bounces back. It would seem that if stocks were purchased at a lower threshold than they would be sold would be the only logical way to handle this.

To continue with the value question, I assume the idea is similar in that the goal of a value index fund is for investors to own a cross-section of relatively cheap stocks? Then once a stock inside the fund is no longer considered cheap by whatever metrics are being used, the stock is sold as it no longer serves a purpose in the fund as a value stock, and ideally investors profit as stocks inside the fund go from cheap to not cheap? I think the reason this has been slightly confusing to me is if I were to buy a stock for very "cheap," I'd naturally want to hold on to it as it transitions from being cheap into fairly priced, but I'm sure there's plenty of growing room up until the "fairly priced" point to where it'd be more profitable than I am currently imagining it to be.

Thank you!

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