What are 'multifactor' ETFs? And do they work?

These funds are designed to weather market twists and turns. The jury, though, is still out.

  • By Michael A. Pollock,
  • The Wall Street Journal
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Crafting a portfolio of exchange-traded funds that will weather market twists and turns can be challenging. But now there’s an ETF for that: the multifactor fund.

Such ETFs offer a way to simultaneously invest in many stocks with different characteristics—also known as factors—such as low volatility, momentum or value that play a role in return. They help investors reduce the risk of getting left behind when certain stocks abruptly fall out of favor and money flows elsewhere in the market.

An investor could engage in the same strategy by owning several narrower-focused ETFs, each focusing on a particular factor, instead. But choosing ones to pair isn’t that easy, professionals say. Multifactor funds offer “a simpler solution for people who don’t feel comfortable mixing their own factor cocktails,” says Ben Johnson, director of global ETF and passive strategies at Morningstar.

Still, while multifactor funds may sound like a great idea, investors should approach them with caution, says Tony Davidow, an allocation strategist at the Schwab Center for Financial Research. Many of these products have come to the market only recently, he says, so the jury is still out as to whether they will perform as expected.

Rising demand

Nevertheless, multifactor funds are a growing area of the fund universe. Fund researcher Morningstar Inc., in a June analysis, tallied some 440 such funds globally with $74 billion in total assets, up from just 37 with $2.5 billion in assets a decade ago.

These ETFs provide the same benefits as some actively managed funds, but at lower cost. They commonly charge about 0.50% of assets annually in expenses, less than half of what many mutual funds charge but more than the traditional market-cap-weighted ETF.

Multifactor funds typically select stocks and weight holdings based on several of the six investment factors that financial experts believe contribute the most to investment performance: stock-market capitalization, low volatility, momentum, valuation, dividend yield, and quality, or companies with strong financial measures such as low debt. Owning such a fund can reduce portfolio volatility when markets swing from factor to factor in terms of what types of stocks are in favor, says Todd Rosenbluth, director of ETF and mutual-fund research at CFRA, a New York-based provider of financial data.

Some experts consider multifactor funds to be a subset of a much larger group of index funds known as “smart beta” ETFs, a term generally used to describe any index-based strategy that weights stocks by something other than market capitalization. Multifactor funds are unique, however, in that they usually target specific factors more precisely in the way they select stocks, says Michael Hunstad, head of quantitative strategies at Northern Trust Asset Management.

But not all multifactor funds are equally well-designed, he says, and that can affect performance.

Indeed, many multifactor ETFs struggle to match the performance of broad market indexes. Two that get relatively higher ratings from Morningstar include iShares Edge MSCI Multifactor USA ETF (LRGF) and Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF (GSLC). The iShares fund focuses on value, quality, momentum and size, while the Goldman Sachs ETF selects securities for value, momentum, quality and low volatility.

Mr. Davidow of Schwab suggests that investors and advisers who don’t want to take the time to scrutinize the sometimes complex approaches used by multifactor funds might follow a more basic approach: owning a very inexpensive market-cap-weighted fund tied to a broad index such as the S&P 500 (.SPX) and pairing it with a narrower ETF. That, he says, would provide diversification in a more cost-effective manner since the higher expenses associated with multifactor funds tend to cancel out some of the benefit of focusing on more than one factor.

“Two individual components would give you a similar outcome, rather than layering in the additional fees and complexity,” he says.

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