Factor timing is difficult, which adds to the case for using multi-factor exchange traded funds. One prominent example is the Principal U.S. Mega-Cap Multi-Factor Index ETF (NasdaqGM: USMC).

USMC, which tries to reflect the performance of the Nasdaq US Mega Cap Select Leaders Index, is comprised of companies with the largest market capitalization taken from the Nasdaq U.S. 500 Large Cap Index and screened based on a quantitative model. The fund implements a multi-factor indexing methodology during its selection process.

USMC offers a straight-forward approach relevant to some of its peers. This distinction proves all the more important as the universe of multi-factor ETFs expands.

“The menu of multifactor funds has expanded considerably over the past decade. As the options have grown, so has investors’ research burden,” writes Morningstar analyst Alex Bryan. “These funds are diverse and often among the most-complex index strategies on the market. While many of these strategies may sound similar, there are important differences in their approaches to portfolio construction, which often yield very different portfolios and performance.”

The USMC Umbrella for a Fickle Market

Momentum, quality, value, size, and even low-volatility are the most widely observed investment factors, but performance differs in any given year. For example, quality and momentum may have outperformed in 2017, but these two factors were the among the worst variables in 2016.

“The case for multifactor funds is the case for diversification. Just as it’s prudent to diversify across asset classes, sectors, regions, and securities, it’s a smart idea to spread bets across multiple factors that each have a good chance of long-term success,” according to Bryan. “Doing so can reduce risk and make it easier to stick with these factors through their inevitable rough patches.”

Compared to the S&P 500 Index, USMC’s underlying index exhibits a higher overweight to the size and low-volatility factor, along with a smaller tilt toward momentum and quality. The Nasdaq U.S. 500 Large Cap Index also includes a heavier overweight to consumer staples, healthcare, and communication services with underweight to industrials, financials, real estate, consumer discretionary, and materials.

USMC YTD Performance

USMC’s starting point, as with any multi-factor ETF, is a vital consideration for advisors and investors.

“This is the selection universe that a fund winnows down to build its portfolio, which is typically a broad index. This is often a good benchmark for the fund’s performance. It may also offer insight into the fund’s potential to outperform,” notes Bryan. “The payoff to most investment factors has historically been the greatest among the smallest stocks, likely due to greater mispricing in that segment. So–all else equal–funds that include small-cap stocks in their selection universe likely have greater room to outperform (or underperform) than funds that are limited to large- and mid-cap stocks.”

For more on multi-factor strategies, visit our Multi-Factor Channel.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.