Single Factor ETFs Can Be Multifactor

June 28, 2017

[This article appears in our August 2017 issue of ETF Report.]

Currently ranked seventh in ETF assets under management in the U.S., with $43.8 billion invested in 89 funds, WisdomTree was one of the first ETF issuers to build its business on smart-beta ETFs. Recently, chatted with Luciano Siracusano, the firm’s chief investment officer, about how WisdomTree’s ETFs fit right in with the ETF industry’s booming multifactor trend. In your opinion, is smart beta about risk reduction or performance enhancement?

Luciano Siracusano: It can be about both. But I think the broader application going forward is viewing smart beta as a potential source of excess return, above and beyond beta. And I feel that’s the big application going forward, particularly if investors move away from mutual funds as their vehicle for trying to generate market-beating performance. That’s really where smart beta has a big opportunity going forward. WisdomTree has always been about earnings- and dividend-focused equity funds. Is WisdomTree looking at anything beyond earnings and dividends for future funds?

Siracusano: I'm not going to comment on future funds now. But I think there's a much greater understanding now about how you actually get exposure to factors like value or quality or profitability over time.

What's interesting is that when people test many different ways to get these exposures, there's something really unique about using dividends or earnings in that they give you exposure to more than one of these factors at the same time.

So rather than think about how a dividend-weighted exposure is giving you exposure to one factor—meaning dividends—what it’s really doing is giving you a way to tap into the value premium, as well as the quality premium. And if you're doing it in a small or midcap space, you also tap into size.

Investors are starting to realize there are ultimately four main smart-beta factors you want to tap into, and earning-weighted and dividend-weighted strategies will typically tap into three of them pretty efficiently: value, quality and size.

The benefit of dividend-weighted is sometimes it also brings down the volatility of the portfolio. That can help them offset some of the hotter volatility you’d typically take on having value or size exposure. Sounds like you see WisdomTree as already offering multifactor funds, which is interesting, because my next question was: “Do multifactor funds work?”

Siracusano: WisdomTree is among the first to offer real multifactor ETFs. The way you can show that over time is to see what the loadings are when you regress against the Fama-French factors.

The WisdomTree ETFs—the dividend ones—will typically load very highly to value, but they also are sensitive to quality. Earnings weighted load pretty well to quality, but also are sensitive to value. That’s something you don’t really see in some of the other fundamentally weighted strategies.

The nice thing about starting with a broad universe of stocks is you also have the potential to lower the tracking error relative to the beta benchmarks. So when we look at the tracking error for the WisdomTree Earnings 500 Index or the total earnings index, those tracking errors were less than 2% over 10 years.

What that means is if you can beat the market by 40 or 50 bps [basis points] annualized with a tracking error of less than 2%, you may end up with a higher information ratio than folks who took on 4%, 5% or 6% tracking error over time.

We think, ultimately, multifactor definitely has a place in the ETF industry. But it really comes down to how much active risk the advisor or investor wants to take. Do you think, in the future, investors are going to be paying more attention to things like factor loading? It seems like we’re hearing more mention of more sophisticated terms like that lately.

Siracusano: Certainly, for the more sophisticated investor, and for the advisor, and certainly as the intermediary, this is something I think is going to become more and more mainstream. After all, people are familiar with Morningstar’s style boxes. But I think you really get to a point where, instead of thinking in terms of value, blend and growth, people are going to say, “It’s not the growth necessarily that I want the exposure to, because growth could just mean very expensive stocks.”

Instead, they may say, “What I really want exposure to is the quality factor and/or the momentum factor that's associated with growth outperforming the market.” So rather than speaking in terms of a style box, I think people are going to gravitate really toward thinking, “Am I getting exposure to the four factors? And if I am, what kind of volatility am I taking on to get that exposure?”


That’s when people might want to introduce a low-vol supplement to the equation, to try to bring the volatility of the portfolio back to the volatility in the actual market.

In terms of what's associated with excess returns, it’s really those four factors. One part is the index methodology, which gives you some indication of what type of factor exposure you're likely to get. And then the second piece of it is, what type of factor exposure did you actually get? That’s what you see when you do the loadings and the regressions.

Typically, you're getting sensitivity to more than one factor at once when you use smart-beta strategies. Some really focus almost entirely on one factor, but in many instances, you're actually getting exposure to more than one factor at the same time.

As a result, the real question is, what happens to the portfolio when you're adding ETFs together? Are you getting exposure to all four? And is there a way to supplement or pare stuff back if you seem to be tilted too much toward one area? I think that’s what people will start to focus on going forward. WisdomTree launched dynamic hedging ETFs at the beginning of 2016. How has the asset growth compared with the permanent-hedge ETFs you launched originally? Do the dynamically hedged funds have stickier assets because investors aren’t switching in and out of them?

Siracusano: With regard to the dynamic currency hedging, the largest ETF we have in that space is the WisdomTree Dynamic Currency Hedged International Equity Fund (DDWM), which covers the broad universe. Today that’s up to about $450 million of assets. It has about a year and a half of history.

We had a very large growth of the shares outstanding in the first few months. And since then, it’s basically been trending hard. It’s at an all-time high, in terms of the shares out. It’s not as if it’s being created and redeemed back and forth.


For the most part, we've had a pretty steady ramp-up in terms of the share creation. That would support the view that people are using it more strategically, with the goal being to try to limit some of the volatility that comes from having that foreign currency exposure.

If you don’t have the core competency to make the currency call, this is going to try to do it for you—to dynamically set it every month as the world changes. Right now it’s about 50% hedged. For most of last year, it was two-thirds to 75% hedged. So it adapts as the world is changing around us. Has the hedging formula been working? Has it been keeping up with whatever changes are happening in the currency trends?

Siracusano: The big trend this year has been a weakening of the dollar. The dollar is down this year, 5.5-6% against the broad basket of currencies. Right now, the strategy is roughly 50% hedged. Six months ago, at the end of the year, it was about two-thirds hedged. It’s reacting to the different movements of currencies relative to the dollar. The goal would be, as the dollar weakens and foreign currencies appreciate, to gradually take on more and more currency exposure.

You're always going to be somewhere between obviously zero and 100, but as a practical matter, you're probably going to be between 16 and 83. Those are really the practical limits that are in the system. It’s not designed to be perfectly aligned with currency movements, but as the dollar is weakening, you gradually have more and more foreign currency exposure. And when that reverses and you get a multiyear cycle of the dollar strengthening, you gradually start to hedge out more of that foreign currency exposure.

Heather Bell can be reached at [email protected].


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