When combining multiple factors, an ETF may take an additive or multiplicative approach. An additive approach would just equally weight the various factors, but this approach runs the risk of diluting factor exposure. The multiplicative approach would overweight stocks that tend to exhibit the stocks with the combined various factors, which may lead to more concentrated factor bets.
“Ensure that your final choices are relatively uncorrelated so that needless factors aren’t included,” Bush said.
In a survey of financial advisors on the webcast, 36% view historical performance of the strategy as the most significant point when evaluating multi-factor strategies while 53% indicated that clarity of the underlying investment process was more important.
Since individual factors may exhibit different returns over the same time period, investors have opted to combine the factors to diversify risk.
“Our research indicates that investors could have outperformed the benchmark by obtaining well diversified exposure across all five factors,” George Rector, ETF Consultant at Deutsche Asset Management, said, referring to the momentum, volatility, value, quality and size factors.
Multi-factor-based index ETF strategies, like 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), help limit correlation and diversify a portfolio to better handle changing conditions over longer periods.
“Although academic research has 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,” Rector said. “In the absence of compelling evidence around timing individual factor strategies, investors may consider using a diversified approach.”
Financial advisors who are interested in learning more about smart beta, factor-based ETF strategies can watch the webcast here on demand.