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Choosing US Multifactor ETFs

Joe Smith

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 features Joe Smith, deputy chief investment officer of Omaha, Nebraska-based CLS Investments.

 

U.S. large-cap multifactor ETFs represent a new way for advisors and their investors to gain access to a unique approach to active management.

These ETFs aim to outperform the market by ensuring the portfolio has a balanced amount of exposure from style factors, including value, momentum, quality, size and low volatility. These factors have been known to explain risk and returns in portfolios.

U.S. large-cap multifactor ETFs took in roughly $3.75 billion in new assets in the last 12 months through the end of February 2019, with total assets now topping $29 billion as of March 22, 2019, according to Morningstar.

Newer entrants—such as the PIMCO RAFI Dynamic Multi-Factor U.S. Equity ETF (MFUS), the Oppenheimer Russell 1000 Dynamic Multifactor ETF (OMFL) and the BlackRock U.S. Equity Factor Rotation ETF (DYNF)—take multifactor investing one step further by rotating among factors as market conditions and economic growth data evolves in order to enhance returns.

The 5 ‘P’s’ Assessment

When it comes to evaluating multifactor ETFs, we believe investors should stick with the five “P’s”: people, philosophy, process, performance and price.

We evaluate the current universe of U.S. large-cap, multifactor ETFs under these dimensions.

1. People

Although factor investing in ETFs is relatively new, it has been implemented by a number of investment firms for years. We believe it is important to understand the team of individuals behind the design and implementation of the ETF, and whether or not the work is being sourced internally or outsourced to a third-party index provider.

For example, the Xtrackers Russell 1000 Comprehensive Factor ETF (DEUS) is designed to track the Russell 1000 Comprehensive Factor Index, run by FTSE/Russell. DYNF, a new actively managed multifactor ETF launched by BlackRock, is driven not by an index, but by the insights and factor rotation model maintained by a team of quantitatively focused investors and thought leaders on factor investing.

The people dedicated to incorporating factors have a significant influence on the ETFs and their outcomes.

 


For a larger view, please click on the image above.


Source: ETF.com; data as of Feb. 25, 2019

 

2. Philosophy

Generally, most practitioners would agree that multifactor investing has inherent benefits. Simply having a strategic allocation to each factor in your portfolio, at minimum, has generally been shown to account for an additional 2% in excess returns per year above the market.

Aside from owning a strategic allocation to factors, others believe investors should tactically rotate between factors on a relative basis to add additional performance to the bottom line. This is often referred to as factor timing, where decisions to overweight or underweight a factor relative to a strategic-policy mix of factors is dependent on the factor’s current valuations, degree of momentum, variability in returns, and what part of the business or economic cycle we are currently in.

The great debate over a strategic versus tactical approach to factors can lead to very different outcomes and have meaningful turnover and transaction costs associated with them.

 

 

3. Process

There are two camps when it comes to constructing a multifactor portfolio. The first focuses on a top-down approach, whereby an investor owns a mix of individual factor “sleeves” and attempts to maintain a balanced allocation to each sleeve.

The alternative camp focuses on a bottoms-up approach, where the investor selects securities that have a reasonable amount of exposure to each targeted factor.

Both processes represent a series of active decisions made within each multifactor ETF, and can carry major implications for what returns are realized. As you can see below, in most cases, size (investing in smaller companies over larger ones) and value seem to be two of the largest factors driving how active these ETFs are.

 


For a larger view, please click on the image above.


Source: ETF.com; data as of Feb. 25, 2019

 

4. Performance

Due to the limited live track record of many multifactor ETFs, it’s difficult to determine what expectations investors should have for these funds and their ability to outperform the market.

On average, for all U.S. large-cap multifactor ETFs, the monthly batting average versus the iShares Russell 1000 (IWB) has been just under 43%. Assuming this is a baseline, we can determine a statistical estimate of each fund’s success rate based on their live data and the associated level of uncertainty.

We can clearly see that, for many U.S. large-cap multifactor ETFs, the rate of success may or may not be close to our empirical batting average, and may also carry a much higher degree of “variance” around the true expected success rate. What is refreshing to see, at least, is the expected batting average for each multifactor ETF has the potential to be statistically better than 50% (it likely requires more time to see if that actually plays out).

 


For a larger view, please click on the image above.


Source: ETF.com; data as of Feb. 25, 2019

 

 

5. Price

The pricing of many U.S. large-cap multifactor ETFs seems to be roughly in line with the broader smart-beta ETF universe, with a median net expense ratio of 0.20%. The largest fund, the Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF (GSLC), comes with a price tag of 0.09% and is by far the cheapest. However, other multifactor ETFs have succeeded in gathering assets at much higher price points.

What’s more interesting to note is that for this universe of ETFs, three of the four most expensive U.S. large-cap multifactor ETFs appear more active in terms of factor timing. The John Hancock Multifactor Large Cap ETF (JHML) is the only exception, although the fund is based on the insights of Dimensional Fund Advisors.

The more important point here is that the universe of U.S. large-cap multifactor ETFs is not only competitively priced, multifactor ETFs with baked-in insight on which factors to favor most heavily will cost investors another 9 to 10 basis points in overall expenses.

 


For a larger view, please click on the image above.


Source: ETF.com; data as of Feb. 25, 2019

 

Bottom Line

U.S. large-cap multifactor ETFs represent another way for investors to access active decision-making. Despite the fact that the majority of these ETFs are technically deployed by tracking a rules-based index, there are a number of considerations to evaluate in order to select a multifactor ETF that suits an investor’s goals.

We believe that employing the five “P’s” as due diligence analysts and investment consultants do for traditional active mandates can help investors be better informed on the options available in the multifactor ETF space.

This information is prepared for general information only. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. All opinions expressed herein are subject to change without notice. The graphs and charts contained in this work are for informational purposes only. No graph or chart should be regarded as a guide to investing.

0359-CLS-4/5/2019

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