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Playing Favorites With Multifactor ETFs

Playing favorites here is difficult given that each of these strategies is designed to deliver somewhat different outcomes. 

Ben Johnson, 09/06/2016

The article was published in the August 2016 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor by visiting the website.

In last month's issue, I outlined the case for multifactor exchange-traded funds. This month, I'm naming names: I will take a look at a select group of true-blue multifactor ETFs that invest in large-cap U.S. stocks. I will call out some nuanced but crucial differences in how their underlying indexes are built and what they imply for these funds' risk/return profiles. Finally, I'll name my favorites from this list.

New Kids on the Block
By my count, there are currently eight dyed-in-the-wool multifactor ETFs in the U.S. large-cap space. These funds are all very new. The elder statesman of the bunch, ETFS Diversified-Factor U.S. Large Cap SBUS, was launched in January 2015. These eight funds had collective assets under management of $1.4 billion as of the end of July, and just three of them held more than $100 million of investors' capital. Thus, all of the standard disclaimers about new and untested (though in this case thoroughly back-tested) strategies apply here.

What's in the Mix?
Each of these funds is similar in that their underlying indexes look to exploit some combination of at least three of the six time-tested factors I listed in "The Case for Multifactor ETFs": value, momentum, size, quality, low volatility, and dividends. But from there, the fund's benchmarks differ along a number of dimensions, namely: 1) the factors they seek to combine; 2) how they define those factors; 3) how they weight their constituent stocks; and 4) how the factors are integrated (or not). Seemingly small variances among these funds' indexes across these four dimensions yield meaningfully different risk/return characteristics--which is evident even in the limited amount of live performance data we have to analyze.

As you can see in Exhibit 2, there are six different combinations of factors across these eight funds. The only common factor among them is value, the grand­daddy of them all. Seven of the eight funds look to combine both value and momentum. Just four of the eight take size into account. Also of note is the fact that six of these funds track indexes with a low-volatility component. Each of those six funds had a beta of less than 1 (see Exhibit 1) during the period from December 2015 to July-end 2016. This indicates to me that 1) the low-volatility element is working (it's been put to the test a few times in that span) and 2) it has the potential to dominate the other factors.

It's also important to understand how each fund's index defines the factors it is after. In Exhibit 3, I've included the metrics that each fund's benchmark uses to define value. As you can see, there are five different definitions of value among these eight funds. Four of the eight defer to the classic definition, which relies solely on stocks' price/book value multiple to identify relatively cheap ones. While price/book has been enshrined by academics and practitioners, using it in isolation to home in on value stocks is--in my opinion--less than optimal, in large part because it is so widely used as to run the risk of being diluted. My preference is for a more-comprehensive set of measures to define value, but not so broad as to tip into data-mining territory. Three should suffice.

Ben Johnson is Morningstar’s Director of European ETF Research.

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