Close Close
Popular Financial Topics Discover relevant content from across the suite of ALM legal publications From the Industry More content from ThinkAdvisor and select sponsors Investment Advisor Issue Gallery Read digital editions of Investment Advisor Magazine Tax Facts Get clear, current, and reliable answers to pressing tax questions
Luminaries Awards
ThinkAdvisor

Portfolio > Mutual Funds

Choosing a Multi-Factor ETF

X
Your article was successfully shared with the contacts you provided.

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.

Composition

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.

Geography

A second consideration is the universe in which each set of fund options is available. Getting the multi-factor treatment in the U.S. large-cap space is almost universally available, but if you want complementary versions in international developed and or emerging markets, you begin to be limited in your options. Different fund families have chosen to operate in different market segments. In the long run, your portfolio’s allocation by geography may have a far greater impact on performance than which of the multi-factor options within those segments you chose. One added wrinkle here – some fund firms operate their multi-factor ETFs differently depending upon the geography. You have to ask. Assets Managed

The firms that have thrown their hat in the multi-factor ETF ring run the gamut from Goldman Sachs and JPMorgan to John Hancock and Legg Mason, along with ETF stalwarts iShares and SPDR. Mom-and-pop shops, these are not. Yet, AUM for many of the funds remains stubbornly low, which makes it consideration No. 3. Why are low assets a problem? For starters, there’s a decent likelihood that, at some point, some of these firms throw in the towel. Especially when you consider that factor investing may entail long periods of underperformance. Low returns and an army of competitors is not generally a recipe for success. If picking a fund that might be closed is an issue for your practice, you should consider staying away from the most underfunded options.

Liquidity

Finally, a fourth significant decisional factor, also related to market acceptance, is liquidity. Any ETF shop worth its salt will have a robust capital markets group to hold your hand through any big trade, but at the end of the day you will have to pay the bid-ask spread to get in and out of the funds and you will also usually have to accept some sort of premium or discount to the actual value of the underlying holdings. For thinly traded vehicles, these implicit costs may be higher than you think, and an important consideration when you evaluate the actual expense of the fund. If your trading operation is less sophisticated, then it warrants even more caution when dealing in relatively illiquid funds.

Versions of multi-factor funds have been around for quite some time. Dimensional Fund Advisors has offered advisors the vehicles to tilt toward value and small cap for more than 20 years. Fundamental indexing shops like Research Affiliates and WisdomTree have long espoused the virtues of reweighting within the market cap universe, and in so doing, often end up at least in part with a factor orientation.

Within the last year we’ve seen something of a Cambrian explosion in the offerings available in this space. For advisors, the options can be overwhelming.  If you are trying to put together a multi-factor ETF portfolio, you must look more than skin deep in researching your options by considering these four very important characteristics. Choosing the right funds requires reading the fund material, comparing performance and trading metrics and talking with fund providers to understand what is under the hood so that the performance you see is what you expect.


NOT FOR REPRINT

© 2024 ALM Global, LLC, All Rights Reserved. Request academic re-use from www.copyright.com. All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.