Smart beta exchange traded funds have gained a lot traction in the investment community. The alternative index-based strategies were initially based on a single theme or factor, but now, investors can track multiple-factor investments in a single ETF to gain greater diversification benefits and smooth out their ride.
In the beginning, smart beta ETFs that track a customized portfolio beyond simple market capitalization weights allowed investors to target specific factors like value, growth or volatility to express an investment view based on the current market environment. However, this single-factor methodology presents some risks.
“One challenge presented by single factor investing is that single factors are cyclical, prone to periods of underperformance based on trends in the business cycle,” Jennifer Bender, Director of Research at State Street Global Advisors, said in a note. “For instance, quality is typically associated with the late stages of the business cycle where profits are beginning to slow and corporate leverage is increasing.”
In the current market environment, factors like low volatility, dividend yield and quality have outperformed. While these various factors help investors gain targeted exposure to specific objectives, investors may have more than one outcome in mind. This is where multi-factor smart beta strategies come into play.
Bender pointed out that smart beta ETFs may address an investor’s targeted objectives and not just a single objective, diminish factor cyclicality, which may lead to periods of underperformance, and potentially create better buy and hold exposure for a balanced and diversified portfolio.
“With multi-factor, the low correlation between factors enables investors to take advantage of potential diversification benefits across factors, help improve consistency in performance and thus mitigate concerns of mistiming factors,” Bender added.[related_stories]
Robert Bush, ETF Strategist at Deutsche Asset Management, likens multi-factor investments to Team USA at this year’s Olympics where a strong group benefits from having a diverse skill set.
“The main benefit from sending ‘the whole factor team’ into a portfolio is that their diversified return streams can offset one another, combining to produce a basket of risk premia that perform under a wider variety of economic scenarios,” Bush said in a note.