Multifactor ETF Investing – A Better Way to Index or Not?

Seems as though there’s always a new investing angle cropping up in an attempt to beat the market. We have smart beta, implemented by the robo-advisor Personal Capital, and then the older investment strategies momentum, undervalued and technical analysis. New twists on the index fund front include, equal weight and other tweaks on the traditional market cap weighted fund. The Wisdom Tree Investing firm is dedicated to alternative index fund investing strategies.

Thus far, I’ve stuck with the market cap indexing and dipped into small cap and value indexes to capitalize on their historical outperformance. But, I’m curious to find out whether the multifactor ETFs will have a place in the “research tested” index fund investing sphere.

Hot off the etf.com press is what Sumit Roy calls “Smart Beta 2.0: Multifactor ETFs”. So, what exactly are multifactor ETFs and should you add some of these newer takes on index fund investments to your portfolio?

What’s the Difference Between Single Factor ETFs and Multifactor ETFs?

A single factor ETF sticks with one investment approach-such as an S&P 500 index fund, an all-world international stock fund or the newer iShares Edge MSCI Min Vol USA ETF (USMV). One advantage of most single factor ETFs is their low expense ratios, frequently below 0.15%.

Multifactor ETFs are new entrants into the investing field.

First, let’s back up a bit into the investing research archives. By now, most investors understand that over the long term, index fund investing typically beats active fund management. In short, invest in an S&P 500 fund that copies the holdings in the unmanaged S&P index for a low annual fee of 0.09% and when the S&P goes up, so does your fund and vice versa. Scores of other types of index funds are also available such as small-cap, value, bond fund, international and more. Yet, there are several factors that have been proven to beat a strict diversified market matching index fund approach. These market anomalies or factors that frequently beat the market returns are:

Value stocks-Stocks that are considered undervalued or low priced. These are identified by certain ratios such as book to market, price to earnings, and more.

Small capitalization stocks-Smaller-sized companies frequently grow more quickly than their larger counterparts. This is not surprising as it’s easier for a firm earning $100 million revenue to double in size than it is for one earning $5 billion revenue.

Dividend yield-Stocks with a higher dividend yield may offer greater returns.

Momentum stocks-Stocks advancing in price during the prior three to six months will tend to continue to increase in price.

Although in the past, these factors tended to outperform the broader markets, there’s no guarantee that they will continue to do so in the future. There are no future guarantees in the investment markets. And even if these factors do outperform in the future, there are likely to be periods when strict indexing works out the best.

Multifactor investing combines several factors into one fund in the hope of limiting the underperformance of one factor during a given time period. The idea is that if more factors are combined into one investment, the multifactor ETF will outperform the overall market, with less volatility.

Multifactor ETF Investing Attempts to Capitalize on Market Anomalies

According to a MSCI research paper, "multi-factor index allocations historically have demonstrated similar premiums over the long run to individual factors but with milder fluctuations."

Recently, many fund companies are jumping in on the multifactor ETF investing bandwagon with a variety of factor combinations. Yet, this multifactor investing approach isn’t as easy as it seems - the investment manager must figure out which factors to combine. The Sumit Roy ETF.com article discusses the issues and asks, does the investor want to increase the “risk-adjusted” returns or just limit the fund losses? Investors that tolerate greater risk may prefer a different multifactor ETF fund than conservative investors.

One of the benefits of the multifactor approach is that managers are using computerized algorithms to pick the appropriate stocks for the ETFs. This keeps the management costs down good news for investors. In fact, the new Robo-advisors are at the fore of the computerized investing trend.

But which multifactor ETF should you choose? Morningstar counts 300 funds in this category to date with assets of $251 billion. In fact, this year more multifactor ETFs have been created than any other fund type.

Since most of the funds are newer, long-term performance returns aren’t readily available. The industry states that the market-beating factors may take a long time to show their strength, thus investing in multifactor ETFs should not be a trading strategy, but a buy and hold tactic.  

Whether the multifactor ETFs beat the monkey approach remains to be seen. For those not familiar with “monkey investing”, it’s the idea that you get enough monkeys throwing darts at various portfolios, and one monkey is bound to outperform the others.

Multifactor ETF Investing Drilldown

Following is an inspection of several multifactor ETFs.

Low Risk Multifactor-JPMorgan Diversified Return U.S. Equity ETF (JPUS) has a reasonable 0.29% expense ratio and gives large and mid-cap U.S. stocks scores based on their value, momentum and return on equity factors. It compares the scores against its peers to choose the best candidates for the specific factors. Incidentally, Morningstar found that approximately 82% of its portfolio is the same as the Russell 1000 index.

Value and Momentum Multifactor-The AQR Large Cap Multi-Style (QCELX) mutual fund has a heftier expense ratio at 0.45%. AQR scores each of the 1,000 largest U.S. stocks according to their value, momentum and profitability metrics. The hope is that strong characteristics in one area will make up for weaker ones in another. The portfolio rebalances monthly.

The Kitchen Sink Multifactor-The iShares FactorSelect MSCI USA ETF (LRGF) takes a broader factor scope. This ETF is exposed to value, momentum, small cap and quality indicators. The broad-based multifactor ETF includes large and mid-cap stocks and strives to copy the risk profile of the MSCI USA index with a complicated weighting formula.

Variable Weight Multifactor-The Franklin Templeton multifactor LibertyQ ETF (FLQG), with an expense ratio of 0.35%, concentrates on four factors and apportions the holdings according to factor importance. The funds starts with an index of 570 stocks and weights quality and value factors the heaviest. Momentum and low volatility are smaller factors in calculating stock-index percentages.

Low-Fee Multifactor-The $6 million SODR MSCI USA Quality Mix ETF (QUS) combines value, quality and minimum volatility in an equal weight portfolio. The fund holds 610 large and mid-cap stocks and doesn’t carry momentum stocks. This fund brags a rock-bottom 0.15% expense ratio.

Multifactor ETF Investing Action Steps

If you want to dip your toe into multifactor ETF investing, do your homework first. Examine expense ratios and investment approaches. Personally, the QUS seems promising due to its avoidance of a strategy-momentum investing-that I’m not fond of and the low 0.15% management fee. That said, I’m unclear as to why someone interested in capitalizing on market anomalies might not buy individual small-cap, value or low-volatility ETFs that typically have lower expense ratios.