Pros of Integrated Approach
- The same dollar can be used to invest in multiple factors, potentially creating leverage
- Potential first-order benefits from identifying stocks with well-rounded factor exposures and avoiding those stocks with factor exposures that cancel each other out
Cons of Integrated Approach
- May avoid securities with the highest factor exposures in favor of those with average exposures across all factors, implicitly diluting overall exposure
- Inefficiencies may be introduced from rebalancing high turnover factors (e.g., momentum) and low turnover factors (e.g., value) on the same horizon.
ETFs Using an Integrated Approach
- JPMorgan Diversified Return US Equity ETF (JPUS)
- FlexShares Morningstar US Market Factor Tilt Index Fund (TILT)
- iShares EDGE MSCI Multifactor USA ETF (LRGF)
- John Hancock Multifactor Large Cap ETF (JHML)
At Newfound, we currently advocate for a mixed approach. Using the first generation of factor ETFs, we employ a “build it yourself” approach in our U.S. Factor Defensive Equity portfolio. We believe in this approach for several reasons:
- To date, the majority of research has substantiated the individual factors as historically reliable ways to generate excess risk-adjusted returns; evidence suggesting that securities with multiple simultaneous factor exposures are better is still lacking.
- Mixing provides extreme transparency in what is held and why. Integration requires the extra step of deciding how much to weight each factor in the overall ranking process.
- Factor portfolios have different turnover levels due to the speed at which the factor premium matures. For example, momentum portfolios tend to be very high turnover, while value portfolios tend to be much lower turnover. Integration runs the risk of the portfolio being influenced most heavily by the highest turnover factor it employs. This difference in turnover may actually negate the argument that holdings in the mixed portfolio cancel each other out, as the expensive stocks held in the momentum portfolio may not be held long enough for value to matter. Similarly, the deep value stock may be held for so long in the value sleeve that the short-term negative momentum has little long-term impact.
- The evidence that integrated approaches create a more efficient use of capital than mixed approaches is lacking.
We believe factor investing can be an incredibly useful tool allowing investors to tap into active management approaches at near-passive beta prices.
Multifactor ETFs take this one step further, creating a turnkey solution for tapping into multiple veins of potential outperformance. Care must be taken, however, in selecting a multifactor approach. Which factors are selected and how the portfolio is built can have a large impact on investor experience.
Newfound Research LLC does not hold any of the ETFs referenced. The company is a Boston-based quantitative asset management firm focused on rules-based, outcome-oriented investment strategies. Newfound specializes in tactical asset allocation and risk management solutions. Newfound offers a full suite of tactical ETF managed portfolios covering global equity, U.S. small-cap equity, multi-asset income, fixed-income and liquid alternative asset classes. For more information about Newfound Research, call us at 617-531-9773, visit us at www.thinknewfound.com or email us at [email protected]. For a list of relevant disclosures, click here.