The Future of ETFs or Too Quant-Heavy for the Average Investor?
By Derek M Horstmeyer
Dynamically adjusted multifactor ETFs are not a new concept by any stretch of the imagination. But thanks to advancements in computing, electronic networks, and the maturation of the fund industry, ETFs that are able to automate the process of shifting between market based factors are now readily available for the first time to institutional and retail investors at costs comparable to most other ETF products.
In the past year, five new ETF products have come online from PIMCO and Oppenheimer that specifically mechanically adjust factor weightings in their holdings over time due to market conditions. These new ETFs have collectively seen inflows of over 100% (as a percentage of AUM) since December, with PIMCO’s Dynamic Multi-factor Emerging Markets Equity ETF growing 10 fold in the past six months. Yet, with this investor appetite for these new products, numerous questions remain about their performance, benchmarking, and whether they are appropriate for retail investors.
First off, what exactly are these new ETFs offering investors? Money managers have known for a long time now that certain factors (attributes of a company or stock) are associated with better performance over the long run. These commonly accepted factors are: value, quality, size, volatility, momentum, and yield.
While there are different interpretations and implementations of each of these factors, in general the following attributes of a stock are associated with excess performance – companies that are cheap on a market value to book value measure (or price to sales), firms that are smaller in size, high quality companies (based on ROA), those with low volatility, those with positive price momentum, and finally companies that pay dividends.
What these newly created dynamically adjusted multi-factors ETFs do is shift between factors over the economic cycle. Since different factors are known to perform better in certain economic environments, these ETFs can capture this and deliver excess returns based on this phenomenon. For instance, when the economy is recovering and extending into an expansion period, size and value factors play the best. When the economy begins to slow down, volatility and quality factors lead to excess returns. And when this slow down leads to a contraction, momentum strategies can be added to the volatility and quality factors which add value. So if the fund can front run business cycles with some accuracy, then shifting a portfolio to companies with different factor weighs over time can be beneficial.
And, ETF product managers (especially those on the quant side) are really excited about the power of these factors and what these new ETFs can afford investors – “Value, quality, size, momentum: 55-65% of the alpha that fund managers provide you can be explained by these four factors alone, and if we can now do what the active managers do at a much lower cost, why wouldn’t we??” notes Syed Zamil, Managing Director of Global Investment Strategies, BNY Mellon. Further, according to numerous academic studies once you add in the remaining factors up to 90% of portfolio returns can be explained by the full list of these six factors.
Oppenheimer, PIMCO and others in this space hope that these ETFs will deliver a significant portion of the alpha that active fund managers typically had to put the leg work in to generate, at a fraction of the cost. Mo Haghbin, Head of Beta Solutions Product at Oppenheimer Funds notes that with technological advancements, what used to require a significant amount of time and money from active managers is now just a click away. “We are now at a point where we can combine many of the benefits of active management while maintaining the desired features of indexation. Dynamic multifactor ETFs are an efficient way for investors to access historical drivers of performance but in a rules based and cost effective way. What is unique about the approach is it unshackles investors from the traditional style box and allows the portfolio to adapt to changing market conditions.”
But, of course numerous questions still remain about the complexity of these products and how appropriate they are for retail investors. First off, the question of what becomes the appropriate benchmark to compare performance too is a big unanswered question. Oppenheimer, for instance, states that for their Russell 1000 Dynamic Multifactor ETF (OMFL) they use a custom version of the Russell 1000 which is not market cap weighted, but does have dynamic weights over business cycles. One has to question that if investors cannot fully understand the benchmark that is being constructed, does this leave room for managers to manipulate things and overstate their performance relative to the benchmark of their choosing?
And, this level of complexity in the product may be an issue for some individuals trying to get comfortable with the new ETF, especially retail investors. According to Holly Framsted, Head of US iShares Smart Beta at BlackRock, single factor ETFs have been a more natural transition for clients into factor investing because it aligns well with the Morningstar stylebox, a common way to build US equity exposure. “We work with clients to implement factors in their portfolio, whether that is through multifactor or single factor exposures. While there is a place for both, we have seen early adoption in single factors from stylebox asset allocators because they align with the clients’ existing investment processes.”
Given these valid concerns over complexity and portfolio benchmarking, whether retail investors get comfortable with dynamically adjusted multifactor ETFs as a product is a an open ended question. Will the benefits of factor based alpha grab investors, or will this level of abstraction scare them off – only time will tell.