This analyst blog is part of our coverage of the 2018 Morningstar Investment Conference.
Multifactor investments have proliferated in recent years. As of April 30, Morningstar tagged 440 index mutual funds and exchange-traded funds with the multifactor strategic beta attribute, most of which launched during the past five years. These investments can be grouped into two buckets: mixed and integrated multifactor ETFs. Mixed multifactor ETFs divide their portfolios into individual sleeves that each target a single factor (for example, value, momentum, size, quality, or low volatility).
Conversely, integrated multifactor ETFs target stocks that all fit a number of different factor characteristics. Both aim to achieve a similar goal: adding return to investors portfolios while diversifying sources of risk. But investors must be sure to do their homework to fully understand and use these investments.
Benefits of Diversification
It is most important that multifactor ETFs diversify across uncorrelated factor exposures. Combining factors can help diversify an investor's portfolio so long as the factors are complimentary and not duplicative. For example, Yasmin Dahya from JP Morgan Asset Management considers low volatility and quality to be part of the same factor family. So, investing in both may cancel out much of the diversification benefit. In her opinion, value and momentum pair better than any other two factors. Value and momentum provide diversification, and both have strong opportunity sets in our current economic cycle.
Feifei Li from Research Affiliates added that it's important to avoid data mining when identifying factors, and that factors must have a theoretical basis. Furthermore, investing in too many factors may create a marketlike portfolio and limit the ability to target specific factors.
Antonio Picca from Vanguard noted that investors should understand their investment preferences and stick with them, knowing that factors will go through cycles and that timing factors is difficult. For instance, although value investing has lagged growth investing in recent years, value investors are wise to stay the course. He also noted that one advantage of owning a multifactor ETF rather than building a do-it-yourself multifactor portfolio is that it helps investors stay diversified across factors over time.
Understand the Risk
Investors should know the amount of risk their multifactor ETF is taking, and they should make sure they are comfortable with that risk. Investors should treat multifactor ETFs more like actively managed strategies than passive strategies, according to Picca.
Dahya said that while assets are flowing into recently launched multifactor ETFs, factor investing is not new; it has long been used by hedge funds. Assets aren't necessarily flowing into factor investing, but rather into more liquid vehicles that use a similar investment strategy.