Multi-Factor ETFs: Adding the “Free Lunch” to Factor Investing

By IndexIQ via

In perhaps his most famous quote ever, Harry Markowitz called diversification “the only free lunch in finance.” For investors, the power of diversification is nothing new, and every advisor is well aware of the value of diversifying holdings within any (and every!) portfolio. That means diversifying asset classes, industries, sectors and, of course, individual securities. For the growing number of advisors who are using the power of ETFs to bolster their portfolios, the next step is to apply the wisdom of diversification to the universe of factor investing.

In general, factor investing focuses on a specific investment’s underlying risk profile and the factors that drive its returns. Though the list seems to be growing every day, some of the most common factors used are Value, Size, Quality, and Low Volatility. One thing that makes factor investing so attractive is that it can be applied to any type of asset. Stocks, yes, but also fixed income, alternatives, currency, and commodities. Factors make it possible to identify assets that offer specific benefits for a portfolio,

For advisors, the marriage of factor investing and ETFs has been a match made in heaven, bringing together the well-known advantages of ETFs—tax efficiency, intraday liquidity, and transparency—with the ability to single out a single characteristic and easily add it to a core portfolio. The result: today there are more than 600 smart-beta ETFs on the market with more than $150b in invested assets.

And yet, despite the fast-growing menu, the majority of ETFs in use today are traditional, single-factor ETFs. In fact, in a recent poll by ETF Trends, nearly two-thirds of advisors surveyed responded that they are using single-factor ETFs alone as part of their overall investment strategy. The problem? Single-factor ETFs lack the one thing that can offer every investor that famous “free lunch”: diversification. That’s precisely where multi-factor investing comes to the rescue.

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