There has been a surge of interest in multifactor ETFs during the past few years. These funds, which promise to provide smoother returns and greater upside than the broader market, sound like a fund marketer’s dream.
And investors have embraced them. The assets under management in this emerging niche have swelled from around $2 billion in 2015 to roughly $15 billion this year, according to research firm XTF.com. That mirrors the growth in the number of such funds on offer, which has risen from 39 in 2015 to roughly 120 today.
Yet it’s fair to ask if these funds can really deliver on their promise. And if so, which approaches are working best? Let’s take a closer look.
Academic Theory . . . Put Into Practice
In the early 1990s, University of Chicago professors Eugene Fama and Kenneth French proposed that three factors—market risk, size and value—could be used to build a portfolio that delivers lower volatility and outsize returns.
More specifically, Fama and French found that stocks with low beta, smaller market caps and lower valuations delivered the strongest long-term results. Equally important, these underlying factors tend to show low correlation with one another.
And that should appeal to investors who can’t stomach extreme market swings. That’s because focusing on a single factor, such as value, may lead to short-term underperformance, which in turn could cause investors to bail on a particular investment too quickly. Because multifactor funds limit the underperformance risk, they potentially improve investors' ability to stay invested, said Kal Ghayur, head of the active beta equity business at Goldman Sachs Asset Management (GSAM), in an interview with Morningstar.
Fama and French stressed that this approach isn’t designed to capture short-term gains. Instead, they suggested, the multifactor approach is best applied in time frames that exceed 15 years. That’s a key point to remember because multifactor ETFs have been trading for only a few years and lack long-term track records.
Yet we do have long-term results with this approach, based on the efforts of Dimensional Fund Advisors, which has managed factor-based strategies since 1981. Dimensional initially focused on the company size factor and later emphasized size and value using the research of Fama and French, but since then the firm’s approach has evolved to include profitability as a factor, which helped launch growth-oriented equity portfolios.