Multifactor ETFs thrive, but how do you use them?

Multifactor ETFs, which combine several investment strategies, are the hottest trend in the fund industry today. But the big question for advisers is how to integrate them in a portfolio. Factor investing began with using just one strategy to modify an index, such as iShares Russell 1000 Value ETF (IWD), which was launched in May 2000. But not long after, in September 2000, State Street Global Advisers rolled out the SPDR Technology ETF, which not only specialized in technology, but weighted its holdings equally, rather than by company size. The fund also has minimum revenue and sales growth criteria. Since then, the multifactor ETF industry has grown to 249 funds, by Morningstar Inc.'s reckoning – 42 of which made their debut in the past 12 months. Total assets: more than $61 billion. "There's no question that multifactor has been the smart beta flavor of the month for the past two years," said Dave Nadig, CEO of ETF.com. The basic attraction for investors: The funds offer strategies used by active managers, but at a lower cost than traditional actively managed mutual funds. The attraction for producers: Multifactor funds have higher expense ratios than big index ETFs, which often charge less than 0.10 percentage points a year. The median multifactor funds charges 0.5%. Some providers, such as Goldman Sachs, rely on the cachet of their name and the hint of secret sauce. The largest active beta ETF, Goldman Sachs ActiveBeta U.S. Large-Cap Equity ETF (GSLC), for example, is less than three years old and has $3.1 billion in assets. The fund combines four factors: value, momentum, quality and low volatility. Others, like FirstTrust, have launched suites of multifactor funds. "They really broke this open with their AlphaDex strategy," Mr. Nadig said. The company was one of the first providers out of the gate, and it started with a full site of funds. "There are always a couple of their funds that look phenomenal," Mr. Nadig said. "And they used a traditional wholesaling model that gets their story out." Some providers, such as Northern Trust's FlexShares, have added a factor overlay to traditional strategies, such as dividend investing. FlexShares​ Quality Dividend Index Fund (QDF) and FlexShares International Quality Dividend Index Fund (IQDF), for example, overlay a quality screen for dividend-paying stocks. "Our thesis that quality dividend payers in all sectors produce better returns over time," said Chris Huemmer, senior investment strategist for FlexShares. One of the bigger trends to emerge is adding environmental, social and governance (ESG) factors to traditional index funds. BlackRock Inc., for example, recently made headlines by offering gun-free versions of some of its index funds. Similarly, Nuveen has rolled out a suite of ETFs that adhere to ESG rules. "This is going to be one of the sleeper trends of the decades," Mr. Nadig said. "We'll look back at now as the time period when it began." The question for advisers is how to integrate multifactor funds into a portfolio. A 5% stake in a multifactor fund won't do clients much good except to add bragging rights if the fund fares well.

"Most of the multifactor ETFs are going to be broadly diversified and would be similar to any core equity holding," said Jeff DeMaso, director of research at Adviser Investments. Does his company use them? Nope, even though Vanguard offers one multifactor ETF, the Vanguard U.S. Multifactor ETF (VFMF). "They are new and untested in the real world," Mr. DeMaso said. "I think if someone is going to invest in them, you have to look at them as active strategies – which means they will sometimes outperform and sometimes underperform. You can't time which multifactor ETF will do well when, so you have to be able to hold them through difficult periods."