Do Multifactor ETFs Make Sense?

May 18, 2018

[This article appears in our June 2018 issue of ETF Report. Also, join ETF.com at the Inside Smart Beta & Active ETFs Summit June 6-7, 2018 at Convene Midtown West in New York.]

Multifactor ETFs aren't so much reinventing the wheel as they are The Wheel 2.0. If you accept the premise that maximizing your exposure to one investment factor can help you boost returns and manage risk, then why not attempt the same using two factors, or more?

Sounds great, of course. But the question, as always, is whether it works.

For new products, there isn't enough data for a definitive yes or no. But multifactor ETFs are no longer the young whippersnappers of the ETF world. Half of all multifactor ETFs have a track record longer than three years; 16% have been around for a decade or longer. By now, we have enough data to know whether multifactor ETFs offer an improvement over the base case.

But the numbers aren't that encouraging.

Why Multifactor ETFs?

The philosophy behind multifactor ETFs is simple enough: If one factor is good, two or more must be better. What constitutes a factor, though, is somewhat subjective. Some commonly used factors include:

  • Momentum
  • Style (growth vs. value)
  • Size (small- vs. large-cap)
  • Volatility
  • Quality
  • Liquidity

Many ETFs may in fact be multifactor plays, even if they aren't advertised as such. Small-cap growth funds, for example, are multifactor; as are low-volatility S&P 500 funds or even some commodity ETNs that use liquidity or size screens.

In fact, the largest multifactor ETF on the market, the $5.6 billion FlexShares Morningstar Global Upstream Natural Resources Index Fund (GUNR), isn't explicitly marketed as a multifactor fund. It's only by digging into the literature that you see GUNR's index uses liquidity and size screens to hedge out "factor-specific risks" in the natural resources space.

However, there are many more multifactor ETFs that advertise their multifactor-ness, and with gusto. The common argument in favor of these funds is that they offer a rules-based, transparent alternative for some active management strategies, many of which were really just multifactor investing in disguise. The table below lists the 10 largest multifactor ETFs:

 

Top 10 Largest Multifactor ETFs
Ticker Fund Expense Ratio AUM, $M YTD Return 12-Mo Return 3-Yr Return
GUNR FlexShares Morningstar Global Upstream Natural Resources Index Fund 0.46% 5,613.5 2.38% 18.83% 5.24%
GSLC Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF 0.09% 3,014.5 0.66% 14.94% N/A
SPHD PowerShares S&P 500 High Dividend Low Volatility Portfolio 0.30% 2,588.9 -5.25% 2.66% 10.56%
IGF iShares Global Infrastructure ETF 0.48% 2,549.0 -3.34% 5.15% 3.07%
FV First Trust Dorsey Wright Focus 5 ETF 0.89% 2,545.6 3.53% 17.91% 7.59%
XT iShares Exponential Technologies ETF 0.47% 2,202.5 1.68% 19.60% 13.58%
DGRW WisdomTree US Quality Dividend Growth Fund 0.28% 2,064.1 -2.60% 13.55% 10.77%
QDF FlexShares Quality Dividend Index Fund 0.37% 1,839.7 -1.46% 10.66% 9.40%
FXL First Trust Technology AlphaDEX Fund 0.63% 1,815.8 5.54% 27.17% 15.63%
GEM Goldman Sachs ActiveBeta Emerging Markets Equity ETF 0.45% 1,807.9 1.11% 20.60% N/A

Sources: FactSet, ETF.com. Data as of April 30, 2018.

 

Many Choices, Few Assets

Excluding leveraged and inverse funds, there are now 303 funds that FactSet classifies as "multifactor," totaling some $81.7 billion in assets under management.

That's not an insubstantial number, yet multifactor funds remain just a sliver (2%) of total ETF assets. They're not even a particularly popular subset of smart beta: Although nearly one out of every three (31%) smart-beta ETFs is now a multifactor fund, multifactor ETFs only account for 10% of total smart-beta assets.

Yet that might be changing, as institutional investors increasingly turn to these strategies as replacements for active management. The 2017 Greenwich Associates 2017 U.S. Exchange-Traded Funds Study found that more than half of U.S. institutional investors (53%) used multifactor smart-beta funds—slightly more than the 50% of investors who used single-factor funds.

Furthermore, 48% of investors who planned to increase their allocation to smart-beta funds over the coming year specifically planned to use multifactor funds (read more at: "Top 5 New Institutional ETF Trends").

Performance Lags The Market

That's great, but the question remains: Do multifactor ETFs live up to the promise of better risk-adjusted returns?

The answer is a resounding no.

For the 252 multifactor ETFs with track records of 12 months or more, the average one-year return is 11.21%, while the average three-year annualized return is 5.24%. (The results are numerically the same for the entire group of multifactor ETFs, without considering length of track record.)

The SPDR S&P 500 ETF Trust (SPY), meanwhile, has a one-year return of 12.22%, and three-year annualized returns of 9.80%:

 

Performance Of Multifactor ETFs vs SPY
  1-Yr Return 3-Yr Return
SPDR S&P 500 ETF Trust (SPY) 12.22% 9.80%
Funds With Track Record ≥ 12 months  11.21% 5.24%
Funds With Track Record ≥ 3 Years 11.18% 5.24%
Funds With Track Record ≥ 5 Years 10.77% 4.57%
Funds With Track Record  ≥ 10 Years 9.30% 3.52%

Sources: FactSet, ETF.com. Data as of April 30, 2018. Multifactor ETF returns are averages.

 

 

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