Many investors have misconceptions about multifactor ETFs, which can serve a powerful role in portfolios.
Multifactor ETFs target desired return-enhancing factors and reduce exposure to unrewarded risk exposures. However, multifactor ETFs have unique strategies, making it important for investors to look under the hood at individual funds instead of making assumptions about the entire category.
1. Assuming Each Factor Has Its Own Sleeve in the Portfolio
The many multifactor ETFs available to investors can largely be divided into two groups: isolated and integrated. Both isolated/mixed and integrated multifactor ETFs look to achieve similar goals, but they use very different approaches.
An isolated factor portfolio, also referred to as mixed multifactor ETFs, gives each individual factor a portion, or sleeve, of the portfolio. The targeted single factor could be value, low volatility, or another factor. Then, the different factor sleeves are then combined.
The Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF (GSLC) is an example of an isolated factor portfolio.
This approach can introduce unintended exposures. For example, many funds use an equal-weighting strategy to access the size factor. However, equal weighting also tends to raise volatility and is inherently anti-momentum.
On the other side of multifactor ETF construction is an integrated approach, which selects securities that fit a number of desired factor characteristics.
In an integrated scoring approach to factor implementation, a single composite score comprises the factor scores at the company level. The integrated scoring approach aims to improve the strength and balance of overall factor exposure within a portfolio.
The Hartford Multifactor US Equity ETF (ROUS) is an example of an integrated factor portfolio.
See more: “How Does Multifactor ROUS Stack Up Against IWB?”
2. Assuming Multifactor ETFs Add to Overall Risk in a Portfolio
Many investors assume targeting factors can enhance risk in a portfolio; however, it’s a lot more complicated that that. Some factors are inherently riskier, while others are more defensive. It’s important to remember that each multifactor ETF contains its own cocktail of desired factors.
For example, ROUS targets low valuation (50%), high momentum (30%), and high quality (20%) investment factors. The strategy notably aims to reduce volatility by 15% over a complete market cycle.
Conversely, a dynamic multifactor ETF like the Invesco Russell 1000 Dynamic Multifactor ETF (OMFL)might re-weight securities based on economic cycles and market conditions. This means the fund might target more defensive factors, like low volatility and quality, but at other times it could target small size, which tends to be more volatile, and momentum.
For more news, information, and analysis, visit the Multifactor Channel.
Investing involves risk, including the possible loss of principal.
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