A Multi-Factor ETF Strategy to Participate in Today's Market | ETF Trends

As investors look for ways to better navigate the current markets, one may consider smart beta or multi-factor exchange traded fund strategies designed to help enhance and diversify an investment portfolio.

On the recent webcast, Factor Investing: An Implementation Toolkit for Today’s Market, Matt Raynor, Managing Director, Strategic Client Group, Principal Global Investors, explained that historically, factors have been powerful drivers of returns.

“Five factors – momentum, quality, value, size, and even low-volatility – generated long-term cumulative returns above the broad market. Momentum, quality, value, and size factors boosted long-term returns. Low volatility delivered a smoother ride and mitigated drawdown risk during the most troubling times, compared to the market,” Raynor said.

However, Raynor noted that these individual factors produced uneven returns during different periods or exhibited more cyclical returns. For example, quality and momentum may have outperformed in 2017, but the two factors were also the worst performers in 2016. Consequently, Raynor suggested that investors may want a multi-factor approach as opposed to trying to time single factors. Investors, though, can still tactically over- or underweight single factors to express a market view over the short-term as well.

Looking at the markets today, Todd Jablonski, Chief Investment Officer, Principal Global Asset Allocation, pointed out that we are currently in the decline phase of a normal economic cycle. In this type of environment, we see monetary policy is directionally moving toward easing, low business spending, consumer confidence declines rapidly and inflation gradually declines. Meanwhile, in the markets, the previous exuberance is unsustainable, risk asset performance declines, asset class correlations rise, volatility may remain elevated and the yield curve tends to begin to steepen.

Historically, quality and low-volatility factors have performed well. Additionally, investors have engaged in further portfolio risk reduction.

At Principal, Jablonski explained that they expect mega caps to continue producing from a cash flow and earnings perspective, notably technology companies.

“Those business models will keep distinguishing themselves and rise above other firms,” Jablonski said. “For them, regulation appears to be the only possible headwind to the growth, and at this short/medium term, new regulation threats seem low.”

As a way to help participate in this current market environment, investors can look to something like the Principal U.S. Mega-Cap Multi-Factor Index ETF (NasdaqGM: USMC).

“Within U.S. large cap equities, we like mega caps. Mega caps have unique features. First of all, they are the lowest volatility market cap cohort. Second, they are most of the market. Third, I don’t believe traditional, fundamental active management works well here. Fourth, I don’t want to own an index,” Jablonski added.

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.

Compared to the S&P 500 Index, the Nasdaq U.S. 500 Large Cap 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 while underweight industrials, financials, real estate, consumer discretionary, and materials.

“Mega caps offer attractive return potential. Our research shows that the low volatility factor can be impactful in mega caps. That said, we didn’t build a ‘low volatility solution’. We designed mega cap solution with that’s alternatively weighting using a tilt-based on volatility,” Jeffrey Schwarte, Portfolio Manager, Principal Global Equities, said.

Financial advisors who are interested in learning more can watch the webcast here on demand.