Equity investors face some challenges in today’s environment, but people can look to multi-factor ETFs in seeking enhanced return and diversification potential.
On the recent webcast (available On Demand for CE Credit), Arnott on Smart Beta: A Better Way Forward with Multi-Factor, Raji O. Manasseh, Equity Strategist at PIMCO, warned that future returns are likely to be lower in light of strong returns achieved since the financial crisis, projecting lower single-digit returns for many markets in the years ahead as opposed to the double-digit returns that we have previously enjoyed.
While there is still an ongoing desire for alpha generation, many have grown dissatisfied with the high costs and underperformance in many actively managed fund strategies, notably those in U.S. equities, Manasseh added.
Consequently, Manasseh pointed to the rising demand for smart beta strategies, especially multi-factor investments, among financial advisors seeking to enhance returns while managing downside risks.
Robert Arnott, Founder and Chairman of Research Affiliates, highlighted the academically and historically backed data that showed certain equity factors have been linked to enhanced returns, notably factors like momentum, value, size and quality. These types of factor investments have been traditionally associated with actively managed investments, but now, investors may find rules-based indexing methodologies that incorporate these active factors in a low-cost ETF investment wrapper.
At Research Affiliates, Arnott marked the so-called fundamental indexing methodology that focuses on factors like sales, cash flow, dividends and book value to break the link between prices and portfolio weights. In contrast, traditional market capitalization-weighted indexing methodologies inherently overweight overpriced companies and underweight underpriced companies, which could result in a return drag.
Investors who have looked into smart beta strategies may note that single factors may exhibit cyclical trends across varying market conditions. Manasseh also warned that individual factors may be volatile, so investors should consider a multi-factor approach that combines the individual factors as a way to potentially smooth out the ride.
For example, the PIMCO RAFI Dynamic Multi-Factor U.S. Equity ETF (NYSEArca: MFUS), PIMCO RAFI Dynamic Multi-Factor International Equity ETF (NYSEArca: MFDX) and PIMCO RAFI Dynamic Multi-Factor Emerging Markets Equity ETF (NYSEArca: MFEM) are designed to be an improved multi-factor solution and dynamically adjust their factor allocations in an ever-changing market environment.
“RAFI Dynamic Multi-Factor is a smart beta equity strategy that seeks to offer diversified factor exposures through allocations to value, quality, low volatility, momentum, and size,” Arnott said.
Arnott also emphasized the dynamic weighting process that hopes to enhance the valuation of the ETF portfolios. The dynamic aspect starts with an equal weighting to each factor plus an additional weight based on a calculation of a factor’s standard momentum and long-term reversal signal relative to other factors. The additional weights to a specific factor are capped at a max of 15% and a minimum of -15% relative to the equal weights.
The methodology also creates factor portfolios focused on an individual factor other than momentum. These factor based sugroups are reconstituted in four so-called tranches with each tranche reconstituted in each quarter. The staggered rebalancing is intended to diversify risk.
Financial advisors who want to learn more about smart beta and multi-factor investing can watch the webcast here on demand.