Smart Beta 2.0: Multifactor ETFs, Here's How They Work

August 19, 2016

Single-factor exchange-traded funds have been around for a while and have gained a wide following with investors.

From the 16-year-old iShares Russell 1000 Value ETF (IWD) with $30 billion in assets, to the younger iShares Edge MSCI Min Vol USA ETF (USMV)―which has nearly doubled its assets this year alone―single-factor funds have made a big mark on the ETF landscape.

The same can't be said for multifactor ETFs. A relatively nascent segment of the ETF universe, multifactor funds have yet to catch on with investors to the same extent. However, that could soon change as investors learn more about these products, many of which have launched just this year.

Why Multifactor?

An article on ETF.com from earlier this year summarized the key points regarding factor investing. In short, there are six factors that have historically earned a long-term risk premium: value, low size, momentum, low volatility, high yield and quality.  

As the article points out, there's no guarantee these factors will continue to outperform―and even if they do―historically, there have been long periods of underperformance against the broader market.

That's where multifactor indexes come in. By combining factors, these indexes offer diversification, limiting the impact of one factor underperforming in any given time period. According to a MSCI research paper, "multi-factor index allocations historically have demonstrated similar premiums over the long run to individual factors but with milder fluctuations."

Risk Varies Among Factors

If that remains true going forward, there's a strong case to be made for multifactor investing over single-factor investing. But it also raises the next question: Which factors should be combined?

The aforementioned research paper suggests that the answer to that depends on a number of things. First, does an investor want to increase risk-adjusted returns or limit downside risk? An investor with a greater risk tolerance could add some of the riskier factors into the mix, while an investor with a lower tolerance could shun those factors.

Using data on global equities, the paper found that the minimum-volatility, quality and high-yield factors historically had lower risk than the broader market. On the other hand, the value, momentum and low-size factors had risk comparable to the market or higher than the market.

In terms of returns, each of the six factors has historically outperformed the market, but to varying degrees, as can be seen from the chart below:

 

Source: MSCI

 

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