Why Factors Are Cyclical

February 20, 2018

Hougan: Youve launched a series of multifactor ETFs that are built from a bottom-up perspective. That decision lies at the center of a big debate on the best approach to building factor ETFs. Can you talk about why you chose the bottom-up approach?

Haghbin: As with anything else, there are pros and cons to a bottom-up approach versus a top-down approach to factors.

In a bottom-up approach, you’re selecting securities on the basis of how each stock scores across a number of targeted factors. For a security to get a large weight, it would need to score well, not just on one factor such as value, but across multiple targeted factors. It's kind of like a pentathlon, where the overall winner isn't necessarily the athlete that's good at one thing like swimming or running, but rather, an athlete that’s good at all five events.

In contrast, a top-down approach would create a simple combination of the highest-scoring stocks based on individual factor exposures. That approach is much easier to implement, but it critically ignores the interaction between factors at the single-stock level.

You might have a stock that does well on low volatility but poorly on value, and that would counteract a stock that does well on value but has higher volatility. You can end up with mixed exposure and factor dilution at the portfolio level. That’s why we chose the bottom-up approach.

Hougan: Factors are hard to understand for professionals. How are advisors supposed to choose between competing multifactor ETFs?

Haghbin: There are several key dimensions to consider when evaluating a multifactor ETF, or really, when evaluating any ETF.

Some of them are very product-specific: What is the portfolio construction process, what are the historical risks and returns, what is the tax efficiency, how much does the ETF cost, etc. But I think it's also important to evaluate the ETF sponsor and the index provider.

In traditional passive funds, costs are really the major driver, because the objective of those funds is to give you the market return minus the fee. In smart beta, cost isn't the only factor you have to think about. It makes it a little bit harder, but the effort is worth it, because there are a lot of great products out there that give investors flexibility and the tools to build better portfolios.

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