Multifactor ETFs May Be the Smartest Choice

If there’s one trend in the world of exchange-traded funds (ETFs) that’s caught on like wildfire, it has to be the use of smart-beta indexes. Here, funds seek to weight stocks via alternative means versus the more traditional market-cap approach. Today, you can easily buy an ETF like the iShares Core Dividend Growth ETF (DGRO B+) that weights stocks on dividend-growth potential.The idea is to find additional performance by exploiting various fundamental factors. Many of the hundreds of ETFs in the smart-beta space these days hone in on the opportunities.But should investors be focusing their attention on just one factor?The answer could be no. Evidence suggests that using a multifactor approach produces some of the better long-term results. And given the multitude of multifactor ETFs now on the market, the time has never been better to take advantage of using a multifactor strategy in your portfolio.Sign up for Pro and get access to real-time ratings on over 1,900 U.S.-listed ETFs.A Basic Primer on FactorsThe crux of smart-beta is using fundamental indexing to build-out a portfolio of stocks. This generally pivots on so-called factors. Factors are basically metrics that can be attributed and used to compare various securities in an asset class. What constitutes a factor is somewhat subjective. But the idea is that once you build your framework, you can compare a basket of stocks against a common metric.Current commonly used factors include momentum, style (growth vs. value), size (small- vs. large-cap), volatility, quality and the often-ignored liquidity factor. By applying the framework, you can quickly see that Netflix (NFLX) has a better relative strength score than, say, Coca-Cola (KO) and, therefore, would score better on a momentum factor index.Investors seem to love the idea of using factors for their portfolios. By choosing an ETF focused on a specific attribute, investors/advisors can hone in and tailor their portfolios in a precise manner. Looking for “value?” You can get it in a fund like the Invesco S&P 500 Pure Value ETF (RPV B-). This has plenty of appeal for investors. A recent survey by New York Life/Mainstay Investments showed that the majority of ETFs in use today are single-factor ETFs. The survey also showed that nearly two-thirds of advisors are using single-factor ETFs alone as part of their overall investment strategy.The Big Problem with Single FactorsHowever, advisors and investors may want to rethink their approach to smart-beta. That’s because just like how stocks and bonds or tech stocks and utilities perform differently in different markets, factors also don’t always work the same way. They are cyclical.For example, the last few years, investors have feasted on tech stocks and high-growth equities. Momentum and growth strategies have been kings. Single-factor ETFs like the iShares Edge MSCI USA Momentum Factor ETF (MTUM A-) and Vanguard Growth ETF (VUG A-) have been big winners, while other factors have shown underperformance. However, as market sentiment has shifted and investors have sold tech stocks hard, MTUM and VUG have cratered. Value, quality and low-volatility strategies are once again on topThe problem is, most, if not all investors, are pretty bad at market timing. Knowing when to apply and use a certain factor is pretty impossible. And knowing which factor will come out on top is also a fool’s errand. Just take a look at the following table from New York Life. As you can see, performance for factors varies from year to year.A Better ApproachWith no single factor winning year in and year out, investors looking to capitalize on smart-beta are in for a rough time. That is, unless they think differently about their approach. Just as you would own a bunch of different asset class – stocks, bonds, real estate, etc. – because of how they function differently in various markets, you can do the same for factors. Diversification works in the same way.Buy owning a basket of different factors, investors can enhance returns, reduce market timing errors and, ultimately, take advantage of the best smart-beta has to offer. In its report, New York Life took a look at the seven major factors over the last 10 years. Using an equal-weighted multifactor approach – meaning each of the seven factors had the same weight in a portfolio – the multifactor approach produced a higher level of return than the S&P 500 with less risk, 8.85% vs. 8.53%. Moreover, equal weighting all the stocks within each factor managed to push the annual return up to more than 10% annually.The idea is that as the market moves through its cycles, the various factors will move to the leadership position and enhance returns. Diversification at work.To find out more about ETFs exposed to particular countries, check out our ETF Country Exposure tool. Select a particular country from a world map and get a list of all ETFs tracking your pick.Getting Multifactor ExposureWith single-factor investing falling flat over the long haul and market timing nearly impossible, investors wanting to take advantage of smart-beta may be better suited in a multifactor approach. Getting exposure to the concept is fairly easy.You certainly could cobble a portfolio of individual-factor ETFs like MTUM, iShares Edge MSCI USA Quality Factor ETF (QUAL A), etc., and equally weight them. This approach does have validity.Or you could try your hand at one of the new multifactor ETFs that has launched in recent years. Funds like the Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF (GSLC A-) seek to combine factors – usually momentum, volatility, size and quality – into one portfolio. By using these ETFs, investors can gain valuable diversification and factor benefits in one ticker. With nearly $4 billion in assets in GSLC, investors are certainly catching on to the idea that multifactor may be the better bet.The key is how the underlying factors are weighted. If a multifactor ETF skews its holdings toward one or two factors over the others, you may not get the same sort of diversification results. In fact, many of the dynamic multifactor ETFs, like the PIMCO RAFI Dynamic Multi-Factor International Equity ETF (MFDX n/a), have underperformed.All in all, taking a broad approach to smart-beta and factor investing is best. Investors should consider the diversification benefits that a multifactor approach can bring.For more ETF news and analysis, subscribe to our free newsletter.

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