Smart beta is one of the fastest-growing segments in the exchange traded funds universe and within that realm, multi-factor ETFs are increasingly popular.
Over the past few years, money managers and fund sponsors started to roll out rules-based, transparent index ETFs that combined some of the attributes that have historically provided active managers with outperformance, such as prominent investment factors like quality, momentum, value, low volatility and size.
The iShares FactorSelect MSCI USA ETF (NYSEArca: LRGF) is one multi-factor that is thriving. LRGF holds 140 stocks with its two largest sectors weights being technology and healthcare. The ETF’s emphasized factors include momentum, quality and value.
“This fund seeks to maximize its aggregate exposure to stocks with attractive value, momentum, small size, and quality characteristics, while matching the risk level of its parent index, the MSCI USA,” said Morningstar in a recent note. “To achieve this, the fund constructs a portfolio using an optimizer that balances each stock’s targeted factor characteristics against its risk. This can lead to inconsistent factor loadings through time because the optimizer shrinks its allocation to factors as their volatility increases.”
iShares’ FactorSelect ETFs also track smart-beta indices that select components based off four factors, including quality, momentum, value and size. LRGF is part of a five ETF suite of factor select ETFs from iShares, the world’s largest ETF issuer.
Through a multi-factored approach, these new smart-beta ETFs try to deliver enhanced returns and maximize diversification in an attempt to provide potentially improved risk-adjusted returns, compared to traditional market-capitalization-weighted indices.
Specifically, some argue that cap-weighted indices may put an investor at risk of chasing a rally since the best performing stocks would gain the most assets and typically have the largest weight in an index.
“For the value effect, the risk-based explanation seems best. Value stocks tend to have less-attractive prospects than their more-expensive counterparts and may offer higher expected returns as compensation for their higher risk. But behavioral biases could also contribute. Investors may extrapolate past growth (or lack thereof) too far into the future, which may cause the market to undervalue slower-growing value stocks,” adds Morningstar.
Morningstar rates LRGF “bronze” due in part to the fact that the ETF is just under two years old.
For more information on multi-factor strategies, visit our smart beta category.