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

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

Factor Correlations

Another consideration when choosing factors to put together is their correlations with each other. For instance, the value factor has exhibited a low correlation with the momentum and quality factors. Thus, combining the three has "historically achieved smoother returns over time and diversified across multiyear cycles," according to the paper.

The research suggests that investors should also consider a factor's performance during the business cycle. Value, momentum and size "have historically been pro-cyclical, performing well during economic growth and when inflation and interest rates are rising."

In contrast, factors such as quality and low volatility "have historically been defensive, performing well when the macro environment was falling or weak."

Source: MSCI

Combining Single-Factor ETFs

The MSCI paper sums it up by saying "there is no ... combination of factors, that is right for all [investors]."

Likewise, there is no factor ETF that is right for all investors. Each investor must choose a combination of factors that fits the criteria they are looking for. They must also understand that even factor diversification is no guarantee against underperformance against the broader market for significant lengths of time.

With that said, for investors who want to plunge into the multifactor world, there are several ways to do it with ETFs. One option is to simply combine single-factor ETFs.

For example, combining the iShares Russell 1000 Value ETF (IWD) with the iShares Edge MSCI USA Quality Factor ETF (QUAL) and the iShares Edge MSCI USA Momentum Factor ETF (MTUM) is a low-cost way to get exposure to the value, quality and momentum factors in U.S. large- and midcap stocks.

Incidentally, there's a plethora of funds that target individual factors, each doing so in a slightly different way. The returns for different ETFs targeting the same factor can vary dramatically, which is something investors should keep in mind.

Multiple Factors In One ETF

The second way to get exposure to multiple factors is by simply buying multifactor ETFs. These funds give investors access to two or more factors in a single package. The SPDR MSCI Emerging Markets StrategicFactors ETF (QEMM), for instance, targets the value, low-vol and quality factors in emerging market equities.

For U.S. large-cap stocks, the Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF (GSLC) provides exposure to the value, momentum, quality and low-vol factors. The fund has attracted attention for its extremely cheap 0.09% (9 basis points) expense ratio.

Meanwhile, a new suite of ETFs from John Hancock extends the multifactor idea to sector funds, such as the John Hancock Multifactor Financials ETF (JHMF). Though it hasn't attracted much interest in its 11 months on the market, JHMF targets the small-size, value, profitability and momentum factors within the U.S. financial sector.

The three aforementioned ETFs are just a sampling of the many multifactor ETFs available. But while there are others out there, all of the major factor combinations still haven't been covered by multifactor ETFs yet.

More launches are surely forthcoming, but until then, a combination of single-factor ETFs may be necessary to fill the gaps.  

Contact Sumit Roy at [email protected].