Do Multifactor ETFs Make Sense?

[This article appears in our June 2018 issue of ETF Report. Also, join ETF.com at the Inside Smart Beta & Active ETFs Summit June 6-7, 2018 at Convene Midtown West in New York.]

Multifactor ETFs aren't so much reinventing the wheel as they are The Wheel 2.0. If you accept the premise that maximizing your exposure to one investment factor can help you boost returns and manage risk, then why not attempt the same using two factors, or more?

Sounds great, of course. But the question, as always, is whether it works.

For new products, there isn't enough data for a definitive yes or no. But multifactor ETFs are no longer the young whippersnappers of the ETF world. Half of all multifactor ETFs have a track record longer than three years; 16% have been around for a decade or longer. By now, we have enough data to know whether multifactor ETFs offer an improvement over the base case.

But the numbers aren't that encouraging.

Why Multifactor ETFs?

The philosophy behind multifactor ETFs is simple enough: If one factor is good, two or more must be better. What constitutes a factor, though, is somewhat subjective. Some commonly used factors include:

• Momentum
• Style (growth vs. value)
• Size (small- vs. large-cap)
• Volatility
• Quality
• Liquidity

Many ETFs may in fact be multifactor plays, even if they aren't advertised as such. Small-cap growth funds, for example, are multifactor; as are low-volatility S&P 500 funds or even some commodity ETNs that use liquidity or size screens.

In fact, the largest multifactor ETF on the market, the $5.6 billion FlexShares Morningstar Global Upstream Natural Resources Index Fund (GUNR), isn't explicitly marketed as a multifactor fund. It's only by digging into the literature that you see GUNR's index uses liquidity and size screens to hedge out "factor-specific risks" in the natural resources space.

However, there are many more multifactor ETFs that advertise their multifactor-ness, and with gusto. The common argument in favor of these funds is that they offer a rules-based, transparent alternative for some active management strategies, many of which were really just multifactor investing in disguise. The table below lists the 10 largest multifactor ETFs:

Sources: FactSet, ETF.com. Data as of April 30, 2018.

Many Choices, Few Assets

Excluding leveraged and inverse funds, there are now 303 funds that FactSet classifies as "multifactor," totaling some $81.7 billion in assets under management.

That's not an insubstantial number, yet multifactor funds remain just a sliver (2%) of total ETF assets. They're not even a particularly popular subset of smart beta: Although nearly one out of every three (31%) smart-beta ETFs is now a multifactor fund, multifactor ETFs only account for 10% of total smart-beta assets.

Yet that might be changing, as institutional investors increasingly turn to these strategies as replacements for active management. The 2017 Greenwich Associates 2017 U.S. Exchange-Traded Funds Study found that more than half of U.S. institutional investors (53%) used multifactor smart-beta funds—slightly more than the 50% of investors who used single-factor funds.

Furthermore, 48% of investors who planned to increase their allocation to smart-beta funds over the coming year specifically planned to use multifactor funds (read more at: "Top 5 New Institutional ETF Trends").

Performance Lags The Market

That's great, but the question remains: Do multifactor ETFs live up to the promise of better risk-adjusted returns?

The answer is a resounding no.

For the 252 multifactor ETFs with track records of 12 months or more, the average one-year return is 11.21%, while the average three-year annualized return is 5.24%. (The results are numerically the same for the entire group of multifactor ETFs, without considering length of track record.)

The SPDR S&P 500 ETF Trust (SPY), meanwhile, has a one-year return of 12.22%, and three-year annualized returns of 9.80%:

Sources: FactSet, ETF.com. Data as of April 30, 2018. Multifactor ETF returns are averages.

In fact, the older the multifactor ETF, the worse its performance against the broader market tends to be. Funds with track records of more than a decade—the longest-lasting and often the most trusted names in the space—underperformed SPY by almost 3% over the past 12 months, and by more than 6% over the past three years.

Indeed, over the past 10 years, these relative graybeards underperformed SPY 5.24% to 8.62%.

The reverse isn't necessarily true, however: Newer funds with shorter track records aren't exactly blowing SPY out of the water. Multifactor ETFs with a track record of less than three years still underperformed SPY over the past year, 11.27% to 12.22%; while ETFs with a track record of less than 12 months have underperformed SPY year-to-date, -0.06% to 0.42%.

‘Dynamic’ ETFs Underperform, Too

Multifactor ETFs specifically designed to outperform the broader market by mimicking active management aren't doing all that hot, either.

Both PIMCO and Oppenheimer now offer "dynamic" multifactor ETFs—named so because they can alter their indexes’ factor exposures to accommodate changes in the economic cycle. These funds, which are still fairly new, offer an even more "active-ish" approach in the pursuit of better performance and lower risk.

Yet that dynamism doesn't seem to be helping much. Four out of the five dynamic multifactor ETFs lag SPY year-to-date (the longest time frame over which data was available): 

Sources: FactSet, ETF.com. Data as of April 30, 2018.

The only outperformer is the $30 million PIMCO RAFI Dynamic Multi-Factor International Equity ETF (MFDX). Almost 19% of MFDX's portfolio is in financials, and another 17% is in industrials, two sectors that have seen strong growth year-to-date.

Smoother Ride Overall

outperformance isn't the only reason investors turn to factor investing. Risk management is also a top draw; many investors are willing to take a slight hit on performance as long as they can minimize their exposure to downside risks. This is where factor investing—and multifactor ETFs—are supposed to shine.  

Not all multifactor ETFs are designed to minimize volatility—in fact, most aren't—but multifactor ETFs as a whole possess an innate ability to do just that. The average beta of these ETFs is 0.91, meaning that the mere fact you've gone multifactor should result in a modest reduction in portfolio volatility versus the broader market. (Remember: A beta of 1.00 means an ETF moves exactly with the market.)

Meanwhile, the 88 multifactor ETFs that specifically employ low volatility as one of their factors exhibit an average beta of 0.87—a further drop, however slight, compared to multifactor ETFs as a whole.

The 10 low-volatility multifactor ETFs with the lowest betas are shown in the table below:

Sources: FactSet, ETF.com. Data as of April 30, 2018.

Cost Advantage

Multifactor ETFs do offer one big advantage for investors: lower cost.

On average, multifactor ETFs carry a 0.52% expense ratio. That may seem high, especially in a bargain-basement marketplace where most core exposure ETFs now charge in the single basis points. But it's actually lower than smart-beta ETFs as a whole (0.53%), and far cheaper than active management, which can run 1-2% or higher.

Individual multifactor ETFs may also be much cheaper. The $3.0 billion Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF (GSLC), for example, captures factor exposure to value, momentum, quality and low volatility for just 0.09%. Not surprisingly, GSLC is also the second-largest multifactor ETF.

Furthermore, since one multifactor ETF can package the same exposure otherwise offered by several single-factor ETFs, multifactor funds can effectively slash transaction costs.

Conclusion

So we come back to the main question: Are multifactor ETFs a better mousetrap? Our answer: It depends on what you're using them for.

Overall, their performance leaves something to be desired, but they appear to meet their promises when it comes to lower volatility and risk reduction. Plus, if you want to cut costs, it's hard to beat one-stop shopping.

Still, investors would do well to tread carefully in this space, lest they fall victim to the same long-term underperformance plaguing the active funds these multifactor ETFs were designed to replace.