While the roots of multi-factor investing go back decades, you could be forgiven for thinking that this phenomenon happened virtually overnight. Within the span of a year or so, we’ve seen scores of exchange-traded funds seeking to provide exposure to a cocktail of “factors” for the purpose of enhancing returns, reducing risk or both.
What is a multi-factor ETF, exactly? In short, these funds typically seek to capture risk-adjusted outperformance that has historically been associated with certain variables that have some ability to explain stock returns – for example, value stocks, those stocks with a low price relative to their book value, cash flows or some other fundamental metric have traditionally outperformed growth stocks, or those with higher price-to-fundamental ratios over long time frames. Often, multi-factor funds are seeking to reweight a market portfolio in order to capture some combination of five major factors: value, momentum, quality/profitability, small cap, and low volatility. As such, they can be thought of as a subset of the phenomenon known as smart beta, which covers a wider array of reweighting schemes.
Multi-factor ETF options provide advisors with an opportunity to implement academic thinking into their client portfolios. That said, with more choices flooding into the market each day, choosing a fund that meets all of your investment criteria can get complicated. When navigating the numerous flavors and options, consider addressing the following characteristics to guide your search.
First and foremost, consider the composition of the fund. Different funds seek to capture a different subset of factors, which will obviously result in different performance. Less intuitively, even funds that purport to target the same factors can have very different performance. Consider the case of two standalone value funds. Is it a passive fund following an index? Or is it among the newer breed of active ETFs, which may not track any published benchmark? If the former, what benchmark does it seek to track? How optimized is it – and ultimately – how much tracking error is there?
Those complications are table stakes when picking any ETF. Multi-factor funds add on an additional layer of methodological choices. Is the fund seeking to overweight factors or be more of a neutral starting point that actually sorts out factor exposures? Is the fund essentially a re-selection and re-weighting of the underlying universe (such as U.S. large cap or emerging broad market) that on average will result in a factor tilt, or is it deliberately taking factor exposure within those markets? Does the fund have tracking error constraints to the broad market? Many of these funds do, in which case the fund might be thought of as more of a core holding – a replacement for your S&P 500, as opposed to a higher octane tilting vehicle that is going to provide a significant overweight to the higher-returning factors.