Under The Hood With Multifactor ETFs

May 08, 2015

Multifactor ETFs are the new budding trend in the smart-beta universe. Issuers have been bringing their multifactor ETFs to market in recent months, looking to combine factor and strategy in a single wrapper.

The State Street lineup of Quality Mix funds is a pioneer of sorts in this segment, with the first flavors of multifactor strategies popping up in 2014. The SPDR MSCI Emerging Markets Quality Mix ETF (QEMM | D-86) came to market last summer. It tracks an index of emerging market securities equally weighted between three subindexes: value, minimum volatility and quality.

While the fund is still very new, it has held its own against the performance of funds such as the iShares MSCI Emerging Market ETF (EEM | B-97).

Courtesy of StockCharts.com

iShares, too, has been recently launching multifactor ETFs, joining the growing fray. But two ETF Securities funds that came to market in January set out to take diversification to a whole new level.

The ETFS Diversified-Factor U.S. Large Cap ETF (SBUS) and the ETFS Diversified-Factor Developed Europe Index Fund (SBEU) are designed with layers upon layers of diversification that involve not only offering exposure to various factors, but they each apply a complex weighting methodology within these factors to minimize other risks associated with stocks.

Eric Shirbini, global product specialist with Edhec Risk Institute, told us these ETFs are designed to deliver better risk/return than a traditional allocation to equities in the long run. We talked to him about what makes these multifactor approaches so innovative, and why investors should care.

We also put his claims to the test of Paul Britt, senior ETF analyst at FactSet. Here’s what they had to say:

1. Factor Diversification

“The reason you want to have multifactor is because factor investing is usually fraught with some kind of drawdown because you’re taking factor risk,” Shirbini says. When one factor has a drawdown, another factor could be doing well, so you’re better off going to the multifactor approach for diversification across factors, according to him.

Paul Britt’s view:

“Funds with more factors can provide more diversification. The other side of the coin is that, for short-term plays, single-factor funds can deliver some huge upside if you’re smart enough or lucky enough to get the timing right. Investors should look at active risk relative to a benchmark (such as ETF.com’s Fit score). In other words, ETFs with the same number of factors (whether one or four) can have hugely different active risk.”

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