Multi-factor ETFs, or smart beta strategies that screen for various market factors, have helped investors enhanced returns over time with diminished downside risks.
“Indexes that blend market factors in an intelligent and systematic way may be an effective tool for long-term investors,” according to FTSE Russell.
Specifically, the index provider looked at the Russell 1000 2Qual/Val 5% Capped Index, the underlying index for the recently launched Xtrackers Russell 1000 US QARP ETF (NYSEArca: QARP), and compared it to the widely observed US large-cap Russell 1000 Index.
FTSE Russell found that the Russell 1000 2Qual/Val 5% Capped Index, which uses a multi-factor methodology to screen for US large cap companies that exhibit strong quality and value characteristics relative to the Russell 1000 Index, was slightly lower in the first quarter. However, the multi-factor indexing methodology outperformed the Russell 1000 for the 6-month, 1, 3, 5 and 10 year periods as of March 31.
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QARP’s underlying index has achieved its strong relative performance in part by capturing 96% of the upward performance of the Russell 1000 and only suffered through 85% of the downward performance of the Russell 1000. Essentially, the smart beta indexing methodology helped investors ride the up trends while limiting the downside to improve overall risk-adjusted returns.
“Smart beta indexes are an exciting and innovative area of the market and, as illustrated in our newest smart beta index measuring US large cap stocks exhibiting strong relative quality and value characteristics, can be an effective way to track a certain area of the market. Our research has shown that, over time, a smart combination of quality and value factors can tap into the best of both,” Tom Goodwin, senior index research director for FTSE Russell, said in a note.
Behind the Scenes of QARP
The smart beta QARP tries to identify companies that have strong quality scores relative to their peers while also looking at the value scores of the securities to avoid companies that are potentially over-priced. The quality focus also seeks to avoid so-called value traps, or companies with favorable valuation metrics as they approach bankruptcy, that a pure value exposure would likely fall into.
The quality factor is calculated from a company’s leverage and profitability and identifies stocks that are characterized by low debt, stable earnings growth, and other “quality” metrics, with the expectation that these will provide the possibility of excess returns.
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The value factor is based on a company’s valuation ratios and identifies stocks that have low prices relative to their fundamental value and that provide the possibility of excess returns.
“At DWS, we believe that multi-factor investing can be a valuable strategy for investors, and we are delighted to continue our collaboration with FTSE Russell to introduce an intuitive multi-factor approach that effectively views the market through the lens of an active manager. Investors seeking stocks with strong Quality metrics—high returns on assets, low accruals, increasing asset efficiency, low leverage—might also prefer such companies at lower valuations, hence QARP – Quality at a Reasonable Price,” Rob Bush, ETF strategist for DWS, said in a note.
For more information on alternative index-based funds, visit our smart beta category.