When Multi-Factor ETFs Make Sense

One of the features of smart beta are investment factors. These are generally portions of a traditional market-cap weighted index, like the S&P 500, that are carved out and packaged into an exchange-traded fund (ETF) via the use of a benchmark created by the ETF issuer.

The theory behind smart beta factors is that by focusing on certain characteristics investors can reap consistent, market beating returns. This is basis of the findings of Fama and French that demonstrated the long-term out performance of small cap stocks versus large caps, and that stocks with lower valuations tend to outperform the market over the long term. Over shorter periods of time certain factors will move in and out of favor, much like certain stocks or market sectors. (For more, see: What Advisors Need to Know about Smart Beta ETFs.)

Diversification is a key investing principal. This, of course, means that an investor shouldn’t put all of their investing eggs into one basket. In a traditional portfolio an investor might divide their holdings between stocks, bonds and cash. They might divide their stock holdings among large, small and mid-caps and international stocks.

For those focusing a part of their portfolio on smart beta ETFs, they may want to diversify among various factors. For example, ETFs focusing on low volatility have been hot of late, but will this continue? According to Morningstar Inc., there are almost 200 multi-factor ETFs available with total assets of about $36 billion. More than one-third of these funds were launched within the past year.

Multi-factor ETFs blend several factors together to ideally minimize the risk of any one factor and to provide a more diversified ETF product to investors. The fact sheet for the SPDR MSCI USA Quality Mix ETF (QUS) indicates that the fund tracks a benchmark called the MSCI USA Quality Mix A-series Index. The index is an equal weighted combination of three MSCI factor indexes: the MSCI USA Value Weighted Index, the MSCI USA Quality Index and the MSCI USA Minimum Volatility index. (For more, see: Are Smart Beta ETFs Active, Passive or Both?)

The fact sheet says that the fund invests in large and mid-cap stocks across these three factors. The fund has a short track record, but over the 12 months ending on August 18, 2016 the ETF has gained 10.06% compared to a gain of 6.63% for the S&P 500 for the same period. Obviously, the performance will need to be monitored over a longer time frame to draw any conclusions. The solid short-term performance reflects the recent gains in low volatility, value and quality ETFs.

According to Ben Johnson, director of global ETF research at Morningstar, there are six main factors that deserve investors' attention: value, momentum, size, quality, low volatility and dividends. “Each of these factors has been researched by multiple scholars and/or professional investors. Many are present across asset classes and in different markets around the world. They have been subse­quently tested out of sample and still pass muster. They are, in a word, legit,” he says.

Owning a single factor-based ETF like the Power Shares S&P 500 Low Volatility ETF (SPLV) can be great when it is “hot.” SPLV has beaten the S&P 500 the past two calendar years and so far in 2016 is ahead of the index by some 300 basis points. (For more, see: Smart Beta ETFs: The Pros and Cons.)

Likewise, the Vanguard Dividend Appreciation ETF (VIG) is beating the index by about 280 basis points year-to-date after trailing the S&P in six of the past seven calendar years.

When considering a multi-factor ETF for a client’s portfolio, financial advisors need to look “under the hood” to understand how the ETF and the underlying benchmark were constructed.

• How are various factors utilized in the ETF?
• Are the factors being combined reasonable, mainstream factors?
• Does the multi-factor ETF’s structure enhance the combined factors’ over-all risk/return profile versus owning any of the various factors on their own?
• How highly correlated to each other are the various underlying individual factors?

According to Morningstar’s Johnson most of the multi-factor ETFs available today use mainstream factors in constructing their custom benchmarks. Johnson suggests that in evaluating the construction of the multi-factor index that simplicity is a good thing. As the adage goes, don’t invest in something that you don’t understand. In the case of single-factor ETFs, the underlying benchmarks are the result of back testing that has varying amounts of actual market performance. (For more, see: How to Explain Smart Beta Strategies to Clients.)

The underlying benchmarks for most multi-factor ETFs have even less actual market data and are the result of combining various single factor benchmarks that themselves have limited actual history in many cases. Add to this some overly complex investment methodology and the level of understanding of whether or not this multi-factor product is worth investing in becomes that much more difficult.

The SPDR MSCI USA Quality Mix ETF has a pretty straightforward benchmark and approach. In contrast, the iShares Edge MSCI Multifactor USA ETF (LRGF) takes a bit of a different approach. According to Barron’s this ETF “…doesn’t combine different baskets of stocks clustered simply by factor. Instead, the Multifactor USA ETF mirrors an index of large and mid-cap stocks distinguished by some combination of value, quality, momentum and relative size. The Multifactor USA ETF is a more concentrated portfolio of 136 stocks that, in aggregate, should deliver more potent factor bets.”

It is also important when considering a multi-factor ETF to remember that these products are new and even more untested than many single-factor ETFs. Advisors and investors need to have reasonable expectations for this part of their portfolio. There will still be volatility but they certainly can mitigate the risk in owning a given single factor ETF. However, investing in stocks will always carry risk and these products are far from immune.

Multi-factor ETFs are a logical progression from the single factor smart beta ETFs that have become quite popular in recent years. If well-conceived and constructed, a multi-factor ETF can be a good vehicle for investors and for financial advisors to use as part of the portfolios they construct for their clients. A solid multi-factor ETF can take several factors and mitigate the risks of owning a single factor product, making it easier for many investors to own and to stick with during a volatile market. Be sure the multi-factor index makes sense and that it is easy to understand and explain to your clients. (For more, see: Smart Beta ETFs: Understanding the Risks.)