Multi-Factor ETFs: What Are They and How Do They Work?

Multi-Factor ETFs: What Are They and How Do They Work?

Investing in Multi-Factor ETFs

Over the past several years, as investors have become a bit more risk conscious and markets have gotten a bit more volatile, there have been products developed to help Main Street investors deal with the changing environment.

Investors looking to get away from the traditional sector or industry ETFs now have a bit more optionality. ETFs that do far more than track a specific sector, but instead, employ entirely different strategies that may be more sophisticated than the average investor can execute on.

Instead, large private equity companies and other institutional investment firms have created products that allow the investor to implement these complex strategies, that are often very successful, into their own personal portfolios.

The best thing about these investment products is that they are far cheaper than having your own investment advisor. The advent of the ETF has allowed the everyday investor to hitch a ride on the strategies that are so lucrative for the big boys, but without the price tags.

A not so common example of one such ETF strategy is known as the multi-factor ETF, which first appeared in 2003. As a relatively new addition to the ETF pool of products, many investors may not know full well what strategy this balanced ETF grants them access to incorporating into their portfolio.

Today, we plan to take even the most beginner of investors through a crash course on what these products can offer them. After, you should have a good enough understanding of what a multi-factor ETF to be in a place where you can determine whether or not this is right for you and your portfolio.

What Are Multi-Factor ETFs?

Multi-factor funds provide exposure to stocks with different characteristics—or factors—such as value and momentum, all in the same product. These ETFs take a broad index and apply a rules-based quantitative process to select stocks based on the chosen factors.

These funds are part of the concept of “smart beta”, which involves building portfolios skewed to factors that have historically been correlated with outperformance (1). These smart beta ETFs include value, dividend generation, momentum, small size, quality, profitability and low volatility.

Much academic research has been done regarding these “factors”.

A landmark 1992 study, by University of Chicago Professor Eugene Fama and Dartmouth College Professor Kenneth French, argued that – based on history – focusing on smaller stocks and those with lower relative prices may improve a portfolio’s expected return (3). Subsequent research conducted by University of Rochester Professor Robert Novy-Marx identified profitability as another factor that enhances expected returns.

The beauty of multi-factor ETFs is that they combine two or more of these elements. This multi-factor investing approach is designed to increase diversification and provide a smoother ride for long-term investors since it sits between passive and active strategies (2).

Take a Vanguard Multifactor ETF as a common example. The stated goal of this fund is to provide long-term capital appreciation by investing in U.S. stocks which target three key factors, value, momentum, and quality. These factors provide the outline of what investments this fund is willing to hold.

The funds’ goal is to provide less risk than passive funds that track broad-based indexes, and at a lower cost than many active funds.

Why Invest in Multi-Factor ETFs?

Some investors dumped multi-factor ETFs late in 2020. That’s because some of these funds underperformed the market average (S&P 500). This was almost solely due to the poor performance of value investing, which by one measure had its worst run for 200 years.

U.S. markets are more concentrated now than they have been in the past 40 years, with the technology sector and stocks such as Amazon (AMZN), Apple (AAPL), Microsoft (MSFT), and Alphabet (GOOGL) representing over 20% of the S&P 500.

So 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 quite often should be diversified away, depending on your individual financial circumstances.

Multi-factor 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, multi-factor 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.

A key strength of these ETFs is their ability to manage the correlation between different factors in a way that a series of single-factor funds could never replicate.

The active returns of single factors have low correlation to each other, so it’s unlikely multiple factors will underperform at the same time. This means diversifying across multiple factors can smooth out your return without reducing performance potential.

Multi-factor funds also have an advantage wherever performance fees are levied, in that they allow the netting of fees. An investor does not have to pay a performance fee for one factor that has shot the lights out, if another has tanked and dragged the overall performance back down.

How Magnifi Can Help You Invest in Multi-Factor ETFs

As is the case with most ETFs, multi-factor ETFs can be bought through any brokerage firm, including with the help of your AI investing assistant. However, you should not invest in these funds blindly. Every investor should understand how a multi-factor ETF can enhance the holdings of your portfolio.

Remember, as with all investing decisions, you will first need to do some due diligence before going off and buying a few shares of your nearest multi-factor ETF. Investors need to look well beyond just the fund’s name in order to make the decision to buy.

For instance, there are many different ways to measure the value factor, including price-to-book (PB), price-to-earnings (P/E), and price-to-sales ratio (P/S). There are also numerous ways to measure profitability, another key factor in these types of investing strategies.

The bottom line is that how a factor is measured can have a major impact on how the fund performs and interacts with the other factors bundled into the fund, as well as your own portfolio.

It is also important to keep in mind that multi-factor funds can have a prominent place in an investor's portfolio, especially during times of increased economic and stock market uncertainty. To understand if these funds can help your portfolio stand up to the changing landscape, continue to do your research and increase your investing confidence.

For help in finding multi-factor ETFs to fit your portfolio, be sure to check out your new AI investing app, Magnifi, for all you need to get started with multifactor ETFs.

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References:

1. “Smart Beta Explained,” Updated April 18, 2021, investopedia.com, https://www.investopedia.com/terms/s/smart-beta.asp
2. “What Is Diversification? Definition as Investing Strategy,” Updated July 01, 2023, investopedia.com, https://www.investopedia.com/terms/d/diversification.asp
3. “What makes smart beta smart?,” March 5, 2018, jhinvestments.com, https://www.jhinvestments.com/viewpoints/investing-basics/what-makes-smart-beta-smart

Disclosures:

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The information and data are as of July 24, 2023 unless otherwise noted and subject to change. This blog is sponsored by Magnifi.

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