Investment Strategies

Why 2016 could be the year of multifactor ETFs

Advisers should assess multifactor ETF options with the due diligence they would apply to an active mutual fund manager

Feb 18, 2016 @ 3:21 pm

By Jay Jacobs

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Smart beta exchange-traded funds have gathered billions in dollars of assets in recent years. Many of these strategies tilt exposure toward an individual factor, or characteristic, that historically has outperformed the broad market, such as value, high momentum, small size or low volatility.

Until recently, these strategies focused on just a single factor. But a new wave of multifactor strategies represents a natural evolution, providing exposure to several factors simultaneously. The reason, academics argue, is to maintain the potential for outperformance associated with factor investing, while diversifying the risks associated with any single factor.

Warren Buffett is an excellent real-world test case for this theory. As a dogmatic value investor, Mr. Buffett has earned his place as one of the greatest investors of all time. Yet since 2012, Berkshire Hathaway's equity investments have underperformed the S&P 500. Cumulatively, Berkshire's returns have trailed the market by nearly -26% over four years. While no one would assert that Mr. Buffett has lost his investing touch, his company's recent performance demonstrates that there are times where value investing falls out of favor with the market. This premise supports the case for multifactor strategies — market dynamics change and factors, like stocks, should be diversified.

For advisers, the proliferation of multifactor ETFs has been rapid and perhaps overwhelming. In 2015, more than 30 multifactor ETFs launched from 10 different ETF issuers, and while they may sound similar in name, their strategies, exposures and portfolio uses can vary dramatically.

As of 2016, Bloomberg calculated that assets under management for these funds make up less than a quarter of a percent of the estimated $450 billion in all U.S. smart beta ETFs. Choppy markets so far in 2016, combined with last year's lackluster performance, have caused investors to rethink their portfolios, particularly allocations to active managers. Multifactor ETFs are well-positioned for the current landscape as investors seek out strategies that balance outperformance potential with enhanced diversification and low management fees.

For the foreseeable future, a number of models are forecasting relatively low equity returns. Economists have argued that the convergence of slowing GDP growth rates in developed markets with the mature state of many industries will lead to lower earnings growth. Valuation models that consider current prices and historical earnings, such as the Shiller P/E, also point to a sluggish future, with implied returns in developed markets totaling approximately 3.2% annualized over the next decade. If realized, these returns would amount to less than half of the MSCI ACWI's annualized 6.8% return from 1994 to 2015.

Despite underwhelming growth prospects, many investors are counting on high future equity returns to meet their retirement goals. Given the potential shortfall, investors either need to accept higher levels of risk or seek out strategies that can add outperformance potential to their portfolios. Well-designed multifactor strategies have the potential to achieve this outperformance as they seek to harvest the return premiums associated with specific factors.

While investors may strive for funds with outperformance potential, there has been a clear migration from higher-priced actively managed funds to lower-cost passively managed funds. According to a Morningstar Inc. study, “Investors are choosing low-cost funds. Over the past decade, 95% of all flows have gone into funds in the lowest-cost quintile. Passive funds have benefited disproportionately.”

The same study shows that the asset-weighted fees for actively managed funds stand at 0.79%, while the asset-weighted management fee for passive multifactor ETFs are nearly half tha,t at 0.45%. The typical low fees of multifactor funds meet the requirements of what many investors have been looking for in their portfolios.

With dozens of new multifactor ETFs available, investors must be judicious in deciphering the differences between the offerings. The differences among multifactor strategies are often more significant than just the management fees and the factors targeted by the methodology. When making decisions for clients, important considerations for advisers include:

1. How does the strategy define each factor? Does it use a definition with academic consensus, such as price-to-book, for the value factor, or is it a proprietary definition?

2. How does the strategy combine its multiple factor exposures? Is it risk-based, equal weighted, or based on combining factor scores?

3. Is the strategy fully transparent or does it include black box optimizers that can add additional unknowable risks?

4. Does the strategy maintain sufficient diversification for a core holding, or is it concentrated in relatively few names?

Advisers should assess their multifactor ETF options with the due diligence they would apply to an active mutual fund manager. It may be more to think about than the approach to more traditional cap-weighted index ETFs, but the combination of potentially lowering fees, providing much-needed outperformance and smoother returns should make it well worth the look.

Jay Jacobs is director of research at Global X Management Company.

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