This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Corey Hoffstein, co-founder and chief investment strategist of Boston-based Newfound Research.
Whether you call it “smart beta,” “strategic beta” or “factor investing,” there is no doubt a new era of commoditized active investing is upon us.
In this era, traditional security selection approaches are distilled into simple rules and packaged as indexes to be tracked by low-cost exchange-traded funds. For example, a classic approach like value investing is repackaged into an index using rules that prescreen stocks for low price-to-book values, price-to-sales values and price-to-earnings ratios.
Of course, there are many, many ways that active investors approach security selection. So ETFs have been launched to track each of these unique approaches—often with very similar ETFs being launched by different sponsors for each approach.
Choice—The Investor’s Burden
Choice becomes the burden of the investor, left to determine not only how they want to invest, but also which sponsor’s method they prefer.
This burden of choice is compounded by the idiosyncratic volatility that can be exhibited by each approach. Even a well-established and well-accepted approach like value investing can go through multiyear performance droughts, causing even the most seasoned investor to second-guess their choice.
Fortunately, in 2016 we’ve seen the rise of multifactor ETFs: products designed to wrap multiple approaches to investing into a single turnkey solution.
The benefits of a multifactor approach can be distilled into a single word: diversification. While each the individual approaches can go through prolonged periods of underperformance, their relative performance often has low, or even negative, correlation to each other.
For example, value and momentum each go through periods of outperformance and underperformance. However, these periods of outperformance and underperformance tend to not occur at the same time. Value tends to outperform when momentum underperforms and vice versa, even though we expect both to outperform over the long run.
While the benefit of multifactor investing is packaged diversification, the proliferation of this approach still leaves investors responsible for peeling back the layers to understand what factors are included and how the portfolios are built.
Which Factors Are You Accessing?
Each ETF offers access to a unique set of factors. While value and momentum are common across most, whether size, low volatility, quality or profitability are included varies greatly.
The following table breaks down the factors in the following ETFs: Global X Scientific Beta US ETF (SCIU); Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF (GSLC); JPMorgan Diversified Return U.S. Equity ETF (JPUS); iShares Edge MSCI Multifactor USA ETF (LRGF | B-79); Franklin LibertyQ Global Equity ETF (FLQG); FlexShares Morningstar US Market Factor Tilt Index Fund (TILT); John Hancock Multifactor Large Cap ETF (JHML | B-91) and ETFS Diversified-Factor U.S. Large Cap Index Fund (SBUS).
It is worth noting that only SBUS and SCIU share common factors. The rest all have a unique mix. And the above table only scratches the surface of approach diversity. For example, ETFs differ in how they measure or identify each factor.
Mixed Or Integrated?
There are two prominent approaches to building multifactor portfolios.
The first is called mixed, where a sleeve of the portfolio is built to represent each factor. For example, in SCIU, a unique sleeve is built to capture the value factor, the size factor, the momentum factor and the low-volatility factor. The ETF then allocates to these four sleeves.
The second approach is called integrated, where each stock is given a combined score for their exposure to each of the included factors. For example, JPUS would look for quality companies trading at an attractive valuation and exhibiting momentum.
Of the ETFs listed above, SCIU, SBUS and GSLC use mixed approaches. The others—JPUS, LRGF, TILT, FLQG and JHML—employ the integrated approach.
The jury is still out as to which approach is better.
When Factors Cancel Each Other Out
In broad strokes, the mixed approach tends to hold securities that have more extreme exposures to the individual factors. However, the mixed approach may also have exposures that appear to cancel each other out. For example, a mixed approach may simultaneously hold a deep value stock with very negative momentum and a very expensive, but high momentum stock.
Integration advocates argue that while they often end up filtering out the most extreme securities in each factor, they get first-order benefits from identifying well-rounded securities and avoiding these exposures that cancel each other out.
At Newfound, we currently advocate for a mixed approach. Using the first generation of factor ETFs, we employ a “build it yourself” approach in our U.S. Factor Defensive Equity portfolio. We believe in this approach for several reasons:
- To date, the majority of research has substantiated the individual factors as historically reliable ways to generate excess risk-adjusted returns; evidence suggesting that securities with multiple simultaneous factor exposures are better is still lacking.
- Mixing provides extreme transparency in what is held and why. Integration requires the extra step of deciding how much to weight each factor in the overall ranking process.
- Factor portfolios have different turnover levels due to the speed at which the factor premium matures. For example, momentum portfolios tend to be very high turnover, while value portfolios tend to be much lower turnover. Integration runs the risk of the portfolio being influenced most heavily by the highest turnover factor it employs. This difference in turnover may actually negate the argument that holdings in the mixed portfolio cancel each other out, as the expensive stocks held in the momentum portfolio may not be held long enough for value to matter. Similarly, the deep value stock may be held for so long in the value sleeve that the short-term negative momentum has little long-term impact.
We believe factor investing can be an incredibly useful tool allowing investors to tap into active management approaches at near-passive beta prices.
Multifactor ETFs take this one step further, creating a turnkey solution for tapping into multiple veins of potential outperformance. Care must be taken, however, in selecting a multifactor approach, as which factors are selected and how the portfolio is built can have a large impact on investor experience.
As of the time of writing, Newfound Research LLC does not own any of the securities referenced above. The company is a Boston-based quantitative asset management firm focused on rules-based, outcome-oriented investment strategies. Newfound specializes in tactical asset allocation and risk management solutions. Founded in August 2008, Newfound offers a full suite of tactical ETF managed portfolios covering global equity, U.S. small-cap equity, multi-asset income, fixed-income and liquid alternative asset classes. For more information about Newfound Research LLC, call us at 617-531-9773, visit us at www.thinknewfound.com or email us at email@example.com. For a list of relevant disclosures, click here.
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