Constructing a Portfolio with Multi-Factor, Smart Beta ETFs

With more options available to fill out an investment portfolio, more investors are eyeing smart beta ETFs, but this opens up new considerations in how to best incorporate these strategies into a diversified portfolio.

On the recent webcast (available on demand for CE Credit), A Practical Guide to Portfolio Construction, Steve Deroian, Head of ETF Strategy at John Hancock Investments, and John Bryson, Head of Portfolio Consulting for John Hancock Investments, argued that the next evolution in portfolio construction is achieved by combining qualities of active and passive investment styles, namely through cheap and efficient smart beta exchange traded fund strategies. Smart beta or strategic beta combines active management insights with the discipline of rules-based approach through the construction of a passive index.

As investors look closer into smart beta ETF strategies, they may find that smart beta is an all-encompassing umbrella that covers many different attributes, such as value, fundamental, momentum, volatility, growth, quality and size, among others. Deroian pointed out that academics claim that hundreds of factors can also be isolated.

“Of course, single-factor strategies also present the risk of having a concentrated exposure to a single factor at the wrong time,” Deroian said.

Alternatively, investors may consider combining these various factor styles into a single strategy to better diversify the individual risks associated with specific factors. Over the 10-year period ended 2016, the a multifactor strategy that combined popular factors like value, quality, size, momentum and volatility has outperformed the individual factors and done so more consistently.

“As their name suggests, multifactor strategies use multiple factors in a single strategy. This factor diversification can lead to a more comprehensive and consistent approach than choosing among single factors. It also takes away the need to rotate in and out of factors,” Deroian said.

Nevertheless, both single- and multi-factor smart beta strategies have a place in a diversified investment portfolio.

“Many investors have embraced both single and multifactor approaches. Typically, they maintain a well-diversified multifactor investment at the core of their portfolio, and make modest over- and under-weights to individual factors around that core,” Deroian said.