As the bull market rally extends and more grow wary of a potential pullback, investors can consider multi-factor, smart beta ETFs to maintain market exposure and limit downside risks.
“It’s been some time since we had a significant pullback in the U.S. market, and so they’re concerned when is that coming and how do we construct our portfolios to handle that,” Abby Woodham, ETF Strategist for Deutsche Asset Management, said at the recent Morningstar ETF Conference. “This is actually a place where a multi-factor investing can do really well because we don’t want to try to time the market.”
For example, Deutsche Asset Management offers a Comprehensive Factor ETF suite, including Deutsche X-trackers Russell 1000 Comprehensive Factor ETF (NYSEArca: DEUS), Deutsche X-trackers FTSE Developed ex US Comprehensive Factor ETF (NYSEArca: DEEF), Deutsche X-trackers Russell 2000 Comprehensive Factor ETF (NYSEArca: DESC) and Deutsche X-trackers FTSE Emerging Comprehensive Factor ETF (NYSEArca: DEMG). The Duetsche X-trackers multi-factor suite selects components based on a broader five factors, including quality, value, momentum, low volatility and size.
“You want to have market exposure but protect towards the downside, and so a multi-factor strategy can have low volatility exposure. It can have high quality exposure. These are things that can help cushion to the downside,” Woodham said.
For buy-and-hold investors, multi-factor investments help combine uncorrelated investment styles to smooth out volatility. Since there are multiple uncorrelated factors at play, it helps guarantee that at least one factor will help support the portfolio during times of distress. Moreover, a multi-factor ETF removes the need for investors to babysit a portfolio and switch between factors in an attempt to time market moves.
The quality factor helps hone in on the quality of a company earnings as a better gauge of future earnings performance. The underlying indices may provide a quantifiable measure of each company’s profitability, efficiency, earnings quality and leverage.
The value factor reflects the idea that cheaper equities are thought to outperform more expensive stocks over the long-term. Consequently, the underlying indices will focus on cash-flow yield, earnings yield and sales-to-price of each company as measures of value.
Momentum may reflect the recent price movements over time as an indicator of future stock price movements. Specifically, the underlying indices review the 11-month cumulative total returns of each stock.
Low volatility suggests that portfolios with less volatility or low beta can provide higher-than-average return with smaller drawdowns. The underling indices will calculate the standard deviation of five years of weekly total local returns for each stock.
Lastly, the size factor reflects the historical long-term effect that show long-term outperformance in small-caps over large-caps. The underlying indices will select companies based on full market capitalization.
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