[This article appears in our June 2017 issue of ETF Report.]
Multifactor investing seeks to combine two or more factor strategies in an effort to provide an edge to exchange-traded fund investing, while adding some complexity.
The strategic-beta space—which is how some refer to smart-beta strategies—includes single-factor and multifactor investing strategies, and has seen significant growth. At the end of March, the strategic-beta space held about $600 billion in assets, according to FactSet and Morningstar.
Broken down by the top three strategies, net assets in value funds were about $153 billion, with growth funds holding around $137 billion, and dividend strategies holding approximately $131 billion, says Elisabeth Kashner, CFA, director of ETF research at FactSet.
Other established factor strategies include quality, low volatility, size and momentum, all of these supported by academic research showing why these factors work over time.
Factors At The Forefront
Of the different factors available and the different firms that offer multifactor funds, two popular combinations are value and momentum. Ben Johnson, CFA, director of global ETF research at Morningstar, says value and momentum are two of the most foundational factors of all factors cited in academic research.
“These bedrock factors are ones where there is fairly broad agreement that these are legitimate. They’re not the end product of some very eager Ph.D. torturing data to tell them that something appears to have some degree of predictive power. ... Value stocks tend to do quite well when momentum is out of favor, and momentum stocks tend to do quite well when value is out of favor,” he said.
John West, CFA, managing director, head of client strategies at Research Affiliates, says that since many of the original strategic-beta funds were based on fundamental indexes, it’s not surprising value is one of the more popular strategies. After the global financial crisis of 2008, low-volatility and quality factors gained fans.
“Low volatility becomes very popular as people witness a 55% loss on their equity portfolio,” West said.
In the past five years, new funds started to include low-volatility and quality factors, he notes, because these factors have performed well.
“They’re popular for the same [reason] that drives everything in our industry: performance chasing. Post-global financial crisis, low volatility has done very well. Quality portfolios had decent bouts of outperformance, and value has done comparably worse,” he added.
Value investing has had a tough go for the past 10 years, West says, although some value strategies have done better than others.
“I think it has enough of a theoretical backing over the very longer term. While it’s taking comparably less of an asset allocation portfolio, most people still view it as being valid. They’re just not happy about it,” he noted.
A Growing Space …
Morningstar’s Johnson says that of all the ETF strategies, strategic-beta funds have ballooned in issuance. At nearly $600 billion in AUM, they represented about 21% of the total amount invested in U.S. ETFs at the end of March. He counts 647 U.S. strategic-beta funds, with roughly half of those products launched in just the past three years.
Ten years ago, First Trust launched its AlphaDex multifactor funds, making the firm one of the original strategic-beta issuers. Ryan Issakainen, CFA, senior vice president and ETF strategist at First Trust, agreed that the sheer number of funds that use multifactor approaches is the biggest difference between now and when they first launched.
“We were definitely an outlier. It took a few years for the investment industry as a whole—the ETF industry specifically—to embrace this type of portfolio strategy,” he said.
Although factors like value and momentum or quality and low volatility are common pairings, that doesn’t mean investors should think these funds are all like. Both West and Johnson say all the multifactor funds have a unique methodology, and advisors should complete as much due diligence with these funds as they would any other active strategy.
… With Many Nuances
Kashner said when FactSet classifies funds, it uses the issuer’s descriptions to classify a fund into a segment. To determine the strategy, inputs, selection and weighting, it scrutinizes the index construction document.
“Funds that fall within strategic beta … either have a classically fundamental analysis that includes items in the income statement or balance sheet. Or they’re technical studies on the movement of prices—low volatility or momentum. Multifactor, by our definition, is some combination of fundamental and technical,” she said.
Research Affiliates’ West says that advisors who are considering multifactor funds need to ask a few questions.
“I think it’s important before you look at a return series, to ask, ‘why do you think this is going to persist?’ What happened in the past is no guarantee it will happen in the future. So, we start by saying, ‘what’s the theory behind this?’” he said.
West says that while issuers need to distinguish themselves in a crowded field, he doesn’t necessarily think one multifactor strategy is better than another.
“I think you can backtest your way into looking a lot better. But the most important thing is to ask, ‘is this a reasonable capture, and am I minimizing my cost of doing so?’” he said.