As a relatively new approach to accessing the markets, multi-factor smart beta exchange traded funds should be fully understood before investors begin shifting core positions from traditional market cap-weighted beta-index funds.
On the recent webcast, Key Questions for Factor Investors, Robert Bush, ETF Strategist at Deutsche Asset Management, argued that investors should consider smart beta investments because they help combine the best features of active, passive and alternative investment approaches.
Specifically, a smart beta portfolio includes attributes research driven strategies to achieve benchmark outperformance, a systematic approach that also comes at a low cost and the ability to potentially capture alpha with cutting edge exposure, according to Bush.
In a survey of financial advisors attending the webcast, 40% of respondents pointed out that they see multi-factor strategies as a way to complement or replace traditional actively managed investments and a way to complement or replace traditional passively managed index strategies. However, over 30% still expressed uncertainty over the multi-factor strategy, which suggests that greater education is needed to promote this burgeoning segment of the ETF industry.
For instance, Deutsche Asset Management offers a Comprehensive Factor ETF suite, including the Deutsche X-trackers Russell 1000 Comprehensive Factor ETF (NYSEArca: DEUS), Deutsche X-trackers FTSE Developed ex US Comprehensive Factor ETF (NYSEArca: DEEF), Deutsche X-trackers Russell 2000 Comprehensive Factor ETF (NYSEArca: DESC) and Deutsche X-trackers FTSE Emerging Comprehensive Factor ETF (NYSEArca: DEMG), which select components based on a broad set of five factors, including quality, value, momentum, low volatility and size.
Brad Zucker, Senior Product Manager at FTSE Russell, explained that FTSE Russell’s indexing methodology targets companies with above average scores in each target factor. Components with higher scores across the five factors will receive a larger weight in the smart beta ETFs.
For instance, Darden Restaurants (NYSE: DRI) scored high across the various factors and received an overweight position in the FTSE Russell’s Comprehensive Factor methodology. However, Amazon (NasdaqGS: AMZN) scored low on its size, value and volatility factors, which contributed to its underweight position.
Arne Noack Exchange Traded Product Development at Deutsche Asset Management, argued that combining the various factors may produce the best results.
“Although academic research identified factors that are important in explaining a stock’s risk and performance, it does not discuss how exposure to these factors could be timed effectively,” Noack said. “In the absence of compelling evidence around timing individual factor strategies, investors may consider using a diversified approach.”
[related_stories]Essentially, a multi-factor basket provides exposure to non-correlated assets as a way to be diversified through various market cycles, so investors would not have micro-manage individual factor investments.
The comprehensive factor exposure has also outperformed benchmark indices as well, with an improved risk-adjusted return.
“Over the past 15 years, adding comprehensive factor index exposure to a traditional 60/40 portfolio significantly increased returns without adding risk,” Noack said.
In the survey of advisors, the majority of respondents indicated that they will likely implement multi-factor investments as either core or satellite holdings, depending on the strategies. Additionally, advisors will make investment decisions based on a combination of historical performance of the strategy, alongside the clarity in the underlying investment process.
SEE MORE: Smart Beta ETFs: Weighing Single- and Multi-Factor Methodologies
Given the current environment, DEUS’s underlying Russell 1000 Comprehensive Factor Index is currently overweight financials, industrials, consumer services, consumer goods, utilities and basic materials, compared to the benchmark Russell 1000 Index.
DEEF’s underlying FTSE Developed ex US Comprehensive Factor Index is overweight industrials, consumer services and utilities, compared to its benchmark FTSE Developed ex US Index.
DESC’s underlying Russell 2000 Comprehensive Factor Index is overweight financials, industrials, consumer services, consumer goods and telecom, compared to its benchmark Russell 2000 Index.
Lastly, DEMG’s FTSE Emerging Comprehensive Factor Index is overweight industrials, consumer services, consumer goods, utilities and basic materials, compared to its benchmark FTSE Emerging Index.
The financial sector is a big theme across the various factor ETFs, which is unsurprising as the area has historically maintained lower quality scores, according to Noack. However, toward the end of the financial crisis, momentum scores in the financial sector began to pick up and measures taken during the crisis helped increase the quality score of the sector, which have lead to slightly larger allocations toward this area of the market.
Financial advisors who are interested in learning more about factor-based investments can watch the webcast here on demand.