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David Stephenson, director of ETF strategy for CIBC Asset Management
What are multifactor ETFs? These are ETFs that offer a way to invest in a diversified portfolio of stocks with different characteristics, also known as factors, such as value or momentum, that have historically played a significant role in explaining stock returns. Multifactor is a form of return-oriented investing that pursues more than one type of factor rather than relying exclusively on a single factor.
Conceptually, multifactor sits nicely between passive and active strategies and leverages the goals of both. It’s an alternative for investors seeking inexpensive diversified equity exposure with market-beating potential. In other words, multifactor ETFs are designed to provide enhanced performance potential and lower risk over passive approaches, tracking broad-based indices while also offering lower cost relative to active approaches in a transparent, rules-based methodology.
How are multifactor ETFs developed? There are many strategies in the market that will pursue similar factors but will deliver different outcomes. Hence, it’s important to understand the construction methodology to assess the strengths and weaknesses of the different strategies. In terms of development, most multifactor ETFs start with a traditional cap-weighted index as a starting universe. So, an example of that could be the S&P 500 index, and target and combine factors to create a portfolio.
There are two ways to develop a multifactor portfolio. The first is called an integrated approach, which pursues stocks with the best overall combination of factor characteristics. For example, it would evaluate each stock in the universe simultaneously on each factor targeted—so company A-B-C on low-vol, momentum and value, and then rank them. The highest ranking stocks would then make the portfolio.
The second approach is called isolated, which splits the portfolios into different sleeves that target a distinct factor. So you would have a value sleeve, a quality sleeve and a momentum sleeve, for example, and then you would combine those sleeves to create a portfolio.
The key message here is no approach is right or wrong, but different ways to develop and construct a multifactor ETF. Understand these approaches and potential advantages and disadvantages and their impact on risk return, as well as controls put in place to manage risk, like sector constraints and rebalancing frequency.
So what factors are commonly combined in the same ETF? What’s interesting about this question is academics and practitioners have documented literally hundreds of different factors, though few are widely accepted as being credible. The most common really amount to just five: value, momentum, size, quality and low volatility. Each of these have been thoroughly vetted and backed by academic research. They are also present across asset classes and in different markets around the world, whether you are investing in Canada, the U.S., Europe or Asia. The good news for Canadian investors is that all Canadian-domiciled ETF providers have exposure to at least two of these five factors, plus maybe dividend and growth, although there may be differences how they define or weight the factors.
How is multifactor different from market-cap-weighted funds tied to broad market indices? To best answer this question, it’s helpful to position how these indices are constructed and the philosophy behind them. Let’s start with market-cap-weighted. Market-cap-weighted indices are designed to mirror the market. They reflect the investment opportunities set available to investors whether we are investing here in Canada, emerging markets, or even Japanese stocks. Market-cap-weighted funds hold the stocks within that universe in accordance with their going market value. Hence, the largest companies will have the highest weights.
A good example would be the S&P 500 index, which represents the U.S. equity market. Microsoft, with a $1 trillion market cap, has the highest weight at approximately 4.1%, while a company like Nordstrom, at a $5 billion dollar market cap, has a weight of about 0.1%. Clearly, Microsoft, with 436 times the weight of Nordstrom, will have more influence on index returns.
In contrast, multifactor ETFs typically take a broad index and adopt a rules-based quantitative process for security selection, seeking to capture more than one factor such as value, momentum or low volatility. Once these holdings are identified, they may be equally weighted, for example. As a result, multifactor can look different from a market-cap-weighted index and have a different risk-return profile. Therefore, it’s important to know what you are buying and do your due diligence just like you would when selecting an active manager.
So, how are they different than buying various single-factor ETFs? With over 800 ETFs now in Canada, there are certainly enough choices for investors. You can buy a pure value or low-volatility ETF on its own, and it’s a perfectly good strategy to do so if you’re looking for a specific exposure to complement and diversify your portfolio or take advantage of a market view.
The case for multifactor ETFs is essentially the case for diversification. Factors are notoriously cyclical and hard to time. For example, one only needs to look at value compared to growth in the last 10 years where growth has significantly outperformed. Ask yourself, “Would you have the patience to have waited for value to outperform over such a long time period?”
Multifactor offers investors diversification across complementary factors and the potential for smoother performance. Multifactor can be used as a core holding or it can complement both active and passive funds. The active returns of single factors have low correlation to each other, so it’s unlikely multiple factors underperform at the same time. This means diversifying across multiple factors can smooth out the ride without reducing performance potential.
So what are some of the potential risks of multifactor ETFs? Like any investment, there are potential risks to consider. Factors aren’t new. Some have been around for decades and are now being harnessed in a liquid ETF wrapper.
Multifactor is also not a silver bullet, meaning it has market environments where it can underperform just as a broad-based market cap fund can. For example, if market performance is concentrated in a select few stocks or a single factor is performing exceptionally well, a multifactor strategy may underperform. If the strategy equal-weights stocks, for example, it may have an inherent small cap bias; if large cap outperforms, this may impact performance. The key is to understand the construction of your fund and the role in your portfolio.
What should advisors consider before recommending multifactor ETFs to clients? Multifactor ETFs in Canada have recently seen a surge in new product development. There is a lot of choice and I would recommend considering understanding your multifactor product and how it is designed and the role it will play in your portfolio. Also from a client perspective, multifactor can instill important behavioural traits. Multifactor can allow investors to focus on long-term returns instead of chasing short-term performance.
Multifactor is also an interesting investment proposition. Academic research has shown that factor-based strategies can outperform broad-based market benchmarks over the long term. And, finally, be mindful of costs. While many of these funds are competitively priced active funds, also consider them relative to a broad market cap index as well. High fees and their potential impact on returns should be examined carefully.