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.”

2. Multifactor Improves Risk/Return

“Our analysis shows that if you go back 40 years on the U.S. market, if you just pick your value stocks and cap-weight them, or if you just value-weight them, you're getting improvement in terms of risk-adjusted return and improvement in the Sharpe ratio around about 30-35 percent,” Shirbini said.

“But if you had diversified instead [through different weighting schemes], you could actually improve that Sharpe ratio to 80 percent over a cap-weighted index, because you’re eliminating some of those risks that you get by being so highly concentrated in such a narrow universe.”

Paul Britt’s View:

“If risk-adjusted outperformance existed in the past, will it continue? Will potential outperformance get arbitraged away? If markets are efficient, then yes.

“Does the increased popularity of factor exposure strategies make them less likely to perform well going forward? Maybe not, given the diversity of strategies at work.”

3. Time Horizon Matters In This Approach

“In the short term, if you invest in a single factor, you will not get consistent outperformance,” Shirbini said. That’s because factor investing exposes you to certain risks beyond market risk. There could be a drawdown associated with those risks.

“Now, those risks are well rewarded over the long term,” he added. “Therefore, it is really important to hold these products for the longer term to benefit from the risk.”

In a multifactor approach, when one factor is experiencing risk, another factor could be doing really well. So, in the short term, you’re going to get differences in performances. But the multibeta approach means you get much smaller differences on a year-to-year basis.

Paul Britt’s View:

“Using our methodology, persistent positive risk-adjusted outperformance or alpha in ETFs as measured by regression against our benchmarks looking back over one-, three- and five-year periods is very rare. Yes, some strategies deliver alpha for a while; sometimes negative, sometimes positive. Persistent positive alpha is obviously very hard to find, but so is persistent negative alpha in our methodology. This makes costs and investor behavior more important. Lower costs help, and complex strategies in ETF wrappers are increasingly cheaper to hold, but so are the cap-weighted approaches. On the behavior side, an investor confident in the strategy may be more inclined to stay the course rather than bailing out at the worst possible time.

“All that said, some investors care little about risk after the fact. If the ETF delivered higher returns than a benchmark regardless of the risk it took, it’s a winner for them.”

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