Smart-Beta, Multi-Factor ETFs Are the Next Big Thing

With exchange traded funds covering most broad index ideas, a new breed of layered, multi-factor strategies could help foster the next leg of growth in the ETF industry.

Following the success of smart beta ETFs that selected components based on a single investment style, such as dividends or low volatility, ETF sponsors are taking the next step and rolling out a number of ETFs that select components based on multiple investment themes, such as dividends, momentum, low volatility and value, which are then all combined into a single ETF. These new multi-factor index ETFs are seen as a way to replicate an active managers’ various investment styles in a cost-efficient, rules-based index fund.

“The industry is creating more transparent and lower-cost versions of the same quant management we’ve seen over the last couple of years,” Lance Humphrey, executive director of global multi-assets at USAA Asset Management Co., the biggest buyer of Goldman’s U.S. multifactor fund, told Bloomberg. “But there are pitfalls. It’s one of my biggest concerns.”

These types of multi-factor strategies are seen as more long-term investment holdings that should be held through up-and-down markets as the ETFs are said to limit market drawdowns and still participate in market gains, potentially providing investors with better risk-adjusted returns over the long run. However, some are worried that many individuals may be tempted to sell when the going gets tough.

“We’re not creating trading vehicles, we’re creating core exposures,” Patrick O’Connor, head of ETFs at Franklin Templeton Investments, told Bloomberg. “It’s still relatively new. There’s definitely folks getting into it, but I think we’re all working on education, which is a good thing.”