This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Corey Hoffstein, co-founder and chief investment strategist of Boston-based Newfound Research.
Whether you call it “smart beta,” “strategic beta” or “factor investing,” there is no doubt a new era of commoditized active investing is upon us.
In this era, traditional security selection approaches are distilled into simple rules and packaged as indexes to be tracked by low-cost exchange-traded funds. For example, a classic approach like value investing is repackaged into an index using rules that prescreen stocks for low price-to-book values, price-to-sales values and price-to-earnings ratios.
Of course, there are many, many ways that active investors approach security selection. So ETFs have been launched to track each of these unique approaches—often with very similar ETFs being launched by different sponsors for each approach.
Choice—The Investor’s Burden
Choice becomes the burden of the investor, left to determine not only how they want to invest, but also which sponsor’s method they prefer.
This burden of choice is compounded by the idiosyncratic volatility that can be exhibited by each approach. Even a well-established and well-accepted approach like value investing can go through multiyear performance droughts, causing even the most seasoned investor to second-guess their choice.
Fortunately, in 2016 we’ve seen the rise of multifactor ETFs: products designed to wrap multiple approaches to investing into a single turnkey solution.
The benefits of a multifactor approach can be distilled into a single word: diversification. While each the individual approaches can go through prolonged periods of underperformance, their relative performance often has low, or even negative, correlation to each other.
For example, value and momentum each go through periods of outperformance and underperformance. However, these periods of outperformance and underperformance tend to not occur at the same time. Value tends to outperform when momentum underperforms and vice versa, even though we expect both to outperform over the long run.
While the benefit of multifactor investing is packaged diversification, the proliferation of this approach still leaves investors responsible for peeling back the layers to understand what factors are included and how the portfolios are built.
Which Factors Are You Accessing?
Each ETF offers access to a unique set of factors. While value and momentum are common across most, whether size, low volatility, quality or profitability are included varies greatly.
The following table breaks down the factors in the following ETFs: Global X Scientific Beta US ETF (SCIU); Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF (GSLC); JPMorgan Diversified Return U.S. Equity ETF (JPUS); iShares Edge MSCI Multifactor USA ETF (LRGF | B-79); Franklin LibertyQ Global Equity ETF (FLQG); FlexShares Morningstar US Market Factor Tilt Index Fund (TILT); John Hancock Multifactor Large Cap ETF (JHML | B-91) and ETFS Diversified-Factor U.S. Large Cap Index Fund (SBUS).
It is worth noting that only SBUS and SCIU share common factors. The rest all have a unique mix. And the above table only scratches the surface of approach diversity. For example, ETFs differ in how they measure or identify each factor.