Multifactor ETFs

As investors seek protection from stock market volatility and potential downturns, products have been developed to take up this challenge. 

One of these types of products is the multifactor ETF, which first appeared in 2003.

What Are Multifactor ETFs? 

Multifactor funds provide exposure to stocks with different characteristics—or factors—such as value and momentum, all in the same product. These ETFs take a broad index, like the S&P 500, and apply a rules-based quantitative process to select stocks based on the chosen factors. 

These funds are part of the concept of “smart beta”, which involves building portfolios skewed to “factors” that have historically been correlated with outperformance. These include value, dividend generation, momentum, small size, quality, profitability and low volatility. 

Much academic research has been done regarding these “factors”. 

A landmark 1992 study, by University of Chicago Professor Eugene Fama and Dartmouth College Professor Kenneth French, argued that – based on history – focusing on smaller stocks and those with lower relative prices may improve a portfolio’s expected return. Subsequent research conducted by University of Rochester Professor Robert Novy-Marx identified profitability as another factor that enhances expected returns.

The beauty of multifactor ETFs is that they combine two or more of these elements. This approach is designed to increase diversification and provide a smoother ride for long-term investors since it sits between passive and active strategies. 

The funds’ goal is to provide less risk than passive funds that track broad-based indexes, and at a lower cost than many active funds. 

Why Invest in Multifactor ETFs? 

Some investors dumped multifactor ETFs late in 2020. That’s because some of these funds underperformed the market average (S&P 500).  This was almost solely due to the poor performance of value investing, which by one measure had its worst run for 200 years. 

U.S. markets are more concentrated now than they have been in the past 40 years, with technology stocks, such as Amazon, Apple, Microsoft and Alphabet representing over 20% of the S&P 500. 

So if an ETF is tracking the S&P 500, the portfolio will be highly concentrated in a few stocks, which will increase stock-specific risk that quite often should be diversified away, depending on your individual financial circumstances. 

Multifactor ETFs seek to provide better risk diversification by identifying companies across a variety of areas, rather than focusing on a small number of heavily concentrated positions. By providing simultaneous exposure to multiple, uncorrelated factors, multifactor ETFs aim to enhance risk-adjusted returns over traditional passive ETFs and provide investors with a more consistent return profile over a full market cycle. 

A key strength of these ETFs is their ability to manage the correlation between different factors in a way that a series of single-factor funds could never replicate. 

The active returns of single factors have low correlation to each other, so it’s unlikely multiple factors will underperform at the same time. This means diversifying across multiple factors can smooth out your return without reducing performance potential.

Multifactor funds also have an advantage wherever performance fees are levied, in that they allow the netting of fees.  An investor does not have to pay a performance fee for one factor that has shot the lights out, if another has tanked and dragged the overall performance back down. 

How to Invest in Multifactor ETFs 

Multifactor ETFs can be bought through any brokerage firm. 

However, you should not invest in these funds blindly. How a multifactor ETF can enhance the existing investments in your portfolio has to be considered.  

You will need to do some due diligence. Investors need to look well beyond just the fund’s name. 

For instance, there are many different ways to measure the value factor, including price-to-book, price-to-earnings, and price-to-sales ratio. There are also numerous ways to measure profitability, another key factor. 

The bottom line is that how a factor is measured can have a major impact on how the fund performs and interacts with the other factors bundled into the fund, as well as your own portfolio.

Importantly, keep in mind that multifactor funds can have a prominent place in portfolios, especially when different investment styles are fighting for dominance.

For help in finding the right multifactor ETF to fit your portfolio, please be sure to check out the Magnifi website under multifactor funds.

Magnifi is changing the way we shop for investments, with the world’s first semantic search engine for finance that helps users discover, compare and buy investment products such as ETFs, mutual funds and stocks. Open a Magnifi investment account today.

The information and data are as of the February 15, 2022 (publish date) unless otherwise noted and subject to change. This blog is sponsored by Magnifi.