Putting together a multifactor ETF is kind of like cooking. A recipe using good ingredients in the right proportion yields a tasty dish, while the wrong mix results in a bland concoction. Similarly, the success or failure of multifactor ETFs rests on the components they use and how they’re put together.
Multifactor ETFs are a recent outgrowth of factor-based investing, a focal point for new product introductions for the ETF industry over the last couple of years. In contrast to fundamental valuation techniques, which look at company-specific characteristics such as earnings or cash flow, these ETFs focus on “factors” that drive risk and return such as a company’s value, momentum, size, quality and volatility. As a selling point, sponsors cite academic studies showing that factor-based investing has produced above-benchmark returns over the long term without increasing risk.
The stampede into factor investing started with single-factor ETFs. While studies show some of these products can produce superior risk-adjusted returns over the long term, they can also underperform for long periods and can be highly cyclical. Investors in single-factor ETFs need to determine which factor to use, when to use it and how to rebalance. To further complicate things, the set of economic and market circumstances that prevailed during a successful period for one factor may not prevail again in the future.
Many believe picking the right time to move into or out of a particular factor can be difficult. “At first glance, stand-alone styles may seem to perform better when cheaper,” noted AQR Capital Management’s Cliff Asness in a paper published earlier this year. (His firm offers a series of multifactor mutual funds.) “This is to be expected as value investing has been shown to be ubiquitously effective. But actually implementing a successful contrarian timing strategy is harder in practice. … We prefer value in conjunction with other styles.”
Multifactor ETFs seek to address the potential shortcomings of single-factor strategies by combining several factors simultaneously. Because factors often have a low correlation to one another, and tend to work well or poorly at different times, advocates say a combination of equity factors can enhance diversification and lead to better long-term risk-adjusted returns. And with a rising correlation among asset classes over the last few years, more investors are looking for an added source of diversification, which multifactor ETFs claim to provide.
A study released by Standard & Poor’s earlier this year supports the idea that timing factors is difficult but also that there are merits to packaging multiple factors into one investment. By itself, the factor of “quality”—defined variously as a company’s profitability, earnings quality, asset growth, leverage, etc.—outperformed the S&P 500 98% of the time during all the five-year rolling investment windows between 1994 and 2017. Companies with low volatility outperformed 92% of the time. But value factor investing alone, by contrast, did much worse, outperforming only 45% of the time during those periods while momentum investing outperformed only 48% of the time.
Topping the performance chart, however, was an index that combined all of these factors in equal exposures, which fared as well or better than the best-performing single factor over all time horizons in the study.
It’s important to keep in mind, in any case, that the multifactor ETF world is still developing. The funds in this space offer very short track records (the majority are less than two years old), different methodologies, different combinations of factors and widely varying returns, all of which make comparison shopping for them extraordinarily challenging.
In 2016, the first full year of operation for many of them, returns for the group ranged from about 9% to 13%. Most of the ETFs draw their constituents from common indices such as the S&P 500 or Russell 1000, but their vastly different sector and stock weightings can translate into returns that diverge from those benchmarks. Depending on how they’re constructed, some ETFs track traditional market-cap-weighted benchmarks more closely than others.
Fund providers trace these funds’ track records with historical back-testing, which doesn’t reflect real-world trading issues or data mining. Expense ratios for some multifactor ETFs are at least twice as high as those of many more traditional market-cap-weighted passive exchange-traded products. Some of the ETFs are fairly new and thinly traded, which could increase trading costs.
Yet even with these issues, a growing number of financial advisors are jumping on the multifactor bandwagon, according to Christopher Huemmer, senior investment strategist at FlexShares, which launched one of the first multifactor ETFs in 2011.
“Financial advisors who focus on active management are using multifactor ETFs as core holdings because they provide lower expenses, greater transparency and better tax efficiency than actively managed mutual funds,” Huemmer says. “Passive index investors are pairing them with core holdings for the same reasons.”
Instead of talking about factor investing as a concept, he says, more recent discussions have shifted to matching multifactor ETFs to client goals. For example, because size and value are long-term cycles, the FlexShares Morningstar U.S. Market Factor Tilt Index Fund (TILT), which focuses on both, is a good choice for clients seeking long-term capital appreciation. On the other hand, a more suitable option for someone with a shorter time frame might be the FlexShares Quality Dividend Index Fund (QDF). This ETF focuses on two factors, quality and dividends, that tend to have shorter cycles for moving in and out of favor.
Most sponsors are newer to multifactor ETFs than FlexShares, but still have offerings worth considering. Goldman Sachs introduced five multifactor, low-expense ETFs in its ActiveBeta series in late 2015. The largest of these, its U.S. large-cap ETF (GSLC), has $2 billion in assets. It charges just 0.09%, where the industry average for the average smart beta offering is 38 basis points. The ETF is divided equally into value, momentum, quality and low volatility stocks using criteria such as companies’ book value, cash flow and sales. It draws most of its names from the S&P 500, though its sector and security weighting differ from that of its stock universe.
State Street Global Advisors launched the first multifactor ETFs in 2014 and now has 10 of them, most covering foreign and emerging markets. Its SPDR MSCI USA StrategicFactors ETF (QUS) measures the performance of large and mid-cap companies across the U.S. equity market, and it contains an equal combination of three factors: value, quality and low volatility. At 0.15%, its expense ratio falls below those of many competitors, but its asset base is relatively small at $35 million. The nine other ETFs in the suite have 0.30% expense ratios.
iShares’ multifactor ETFs include the iShares Edge MSCI Multifactor USA ETF (LRGF). The fund draws its constituents from the MSCI USA Index, a cap-weighted group of mid- and large-cap stocks, and it uses companies’ value, momentum, quality and size as its factors. The fund uses a complex optimizer that balances factor characteristics and risks to select stock components. Launched in April 2015, the ETF has a more value-oriented tilt than some of its peers and has about $430 million in assets and a 0.20% expense ratio, making it one of the cheaper offerings in the group. Other multifactor offerings in the series cover small caps, international stocks and emerging market names, as well as individual sectors such as energy, materials and technology.
John Hancock’s suite of multifactor ETFs consist mainly of offerings in specific U.S. sectors such as energy, financials, technology and consumer discretionary. The firm also has more diversified large-cap, mid-cap and developed international offerings. Based on an index designed by Dimensional Fund Advisors, John Hancock’s Multifactor Large Cap ETF (JHML) is divided into smaller-cap stocks, companies with lower relative prices and companies with higher profitability. Because of its emphasis on the smaller members of the large-cap universe, its weighted average market cap is significantly lower than that of its benchmark, the Russell 1000. The ETF has $347 million in assets and a 0.35% expense ratio.
JPMorgan’s Diversified Return Equity Series covers 10 areas, including international stocks, global stocks, mid-caps, emerging markets equities, alternative investments and U.S. equities. Its Diversified Return U.S. Equity ETF (JPUS) uses the Russell 1000 for its universe, and it divides its stocks into quality, valuation and momentum factors. According to its literature, the fund’s risk-weighting process “results in lower exposure to historically volatile sectors and stocks.” It has $258 million in assets and a 0.19% expense ratio.
The quiet giant in the multifactor ETF space is the FlexShares TILT fund, which has more than $1 billion in assets, a six-year history and a 0.25% expense ratio. The tilts here are toward smaller companies and value, which the firm believes are the strongest drivers of long-term returns.
These ETFs, and others in the multifactor camp, take either an “isolated” or “integrated” approach. An ETF using an isolated approach, such as the Goldman Sachs ActiveBeta U.S. Large Cap Equity fund, segregates stocks into factor sleeves under the umbrella of one portfolio. Those that use an integrated approach, such as iShares Edge MSCI Multifactor USA fund, score each stock based on the combination of chosen factors for the portfolio.
An ETF that uses quality, value and momentum, for example, would identify and select component stocks based on all those characteristics rather than separate them into factor sleeves.
With the track record of these ETFs still so new, the jury is still out about whether the isolated or integrated approach works best. A lot depends on what you’re looking to accomplish.
“Consider an isolated portfolio approach if you favor transparency and lower tracking error, but know that you’re forgoing more-pronounced factor tilts,” wrote Morningstar analyst Adam McCullough in a May 2017 article. “For potentially stronger factor tilts and higher tracking error, consider a fund that uses an integrated approach. But remember that an integrated approach is usually more complex and opaque.”
As ETF sponsors continue to clash over which multifactor recipe works best, investors are left to sort through a complex maze of ETFs with short track records. Once longer-term performance starts filtering in, the decision-making process for investors will be made easier by results based on real world returns rather than academic studies.