Passive investing has soared in popularity in recent years, but there’s another investing concept that financial advisors should keep in their toolbox: multifactor exchange-traded funds.
Multifactor ETFs aim to position their holdings to take advantage of the attributes — or “factors” — best positioned to deliver better long-term, risk-adjusted returns than the overall market. They may target factors such as value, momentum or small size, for instance, or any combination of these.
Unlike single-factor ETFs, such as ETFs that focus only on value stocks, multifactor ETFs target more than one attribute, making them a more diversified approach to factor investing.
Multifactor ETFs look for stocks that have the optimal combination of attributes to meet the fund’s investment objective such as higher return potential or reduced risk, says Brian Miller, head of capital markets and trading at Hartford Funds, whose suite of multifactor ETFs focuses on research-driven, rules-based strategies.
To learn more about how financial advisors can use multifactor ETFs in their practices, we spoke with Miller in a recent interview. Here are edited excerpts from that conversation.
What are multifactor ETFs? Can you explain the different attributes used to define them?
Multifactor ETFs seek stocks with certain attributes that can be optimally combined in a systematic and repeatable manner to attempt to achieve a specific investment objective such as higher return potential or reduced risk relative to the broader market.
Examples of common risk factors include value, momentum, quality, low volatility and small size.
The benefits of these risk factors have been documented through extensive academic research and market performance over several decades. As an example, the value factor is based on evidence that inexpensive stocks relative to their fundamental value have historically outperformed stocks with higher valuations over the long run.
The low volatility factor seeks the least volatile stocks because they have historically produced better risk-adjusted returns than the broader market. The momentum factor favors stocks with stronger relative performance, with the expectation that this price momentum will persist.
The value, small size and momentum factors can provide return-enhancing potential, while more defensive risk factors such as low volatility and quality can be used to reduce risk. We believe these time-tested risk factors work well together and can provide investors with more consistent risk-adjusted returns.
What can multifactor ETFs provide that traditional ETFs cannot?
Multifactor ETFs are research-driven and rules-based strategies based on numerous factors, while traditional passive ETFs are often limited to investing based primarily on company size, which can expose investors to inefficiencies and unintentional risks.
For example, U.S. markets are more concentrated now than they have been in the past 40 years. At the end of 2020, technology stocks Facebook (ticker: FB), Amazon.com ( AMZN), Apple ( AAPL), Microsoft Corp. ( MSFT) and Alphabet ( GOOG, GOOGL) represented approximately 22% of the S&P 500, which was equivalent to the combined weight of the bottom 352 stocks in the index. 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 could be diversified away.
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.
For what type of client would multifactor ETFs be a good fit?
Multifactor ETFs are appealing to both retail and institutional clients looking for core equity exposure in their portfolio.
Clients typically use these products as an alternative to traditional, market-cap weighted ETFs since they offer the outperformance potential or risk reduction benefits of an active manager with the transparency and tax efficiency of an ETF.
These products can also be used as a lower cost alternative to traditional actively managed equity funds. Each client should make sure the multifactor ETF they select aligns with their unique investment objective.
What role could a multifactor ETF play in client portfolios?
Multifactor ETFs can be used as a core equity holding in an investor’s overall portfolio.
These products typically offer diversified equity exposure to broad equity markets such as the U.S., international developed and emerging markets.
Optimally combining attractive risk factors that have a lower correlation with each other in a low-cost, diversified equity ETF vehicle may be a more efficient way to construct portfolios and manage risk compared with traditional approaches.
What are the drawbacks or risks associated with multifactor ETFs?
Multifactor ETFs are based on long-term academic research on how certain risk factors have generated improved returns or reduced risk relative to the overall market. But the methodology used by each multifactor ETF provider to weight, measure and combine these factors differs. It’s important for investors to have a clear understanding of each ETF provider’s approach and how the strategy may perform in different market environments.
For instance, if a multifactor ETF has significant exposure to the value factor, and this factor is out of favor, the ETF’s performance may lag the performance of the overall market during this period. The multifactor ETF will likely benefit from other uncorrelated factors it’s exposed to, however, so the underperformance during this period may be less dramatic than it would be if the ETF were maximizing exposure to value in a single-factor ETF.
Factor diversification and a more consistent return profile are key benefits of multifactor ETFs over single-factor ETFs.
As with any equity-based strategy, these products are likely not appropriate for conservative or risk-averse investors who are not comfortable with the volatility of the equity markets.
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