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By Alex Bryan and Christine Benz | 01-20-2016 12:00 AM

Understanding Multifactor Investing

Morningstar's Alex Bryan reviews several funds that blend multiple factor-based strategies and discusses how investors might use such strategies in their portfolios.

Christine Benz: Hi, I'm Christine Benz for The exchange-traded fund industry has recently seen a flurry of multifactor ETF launches. Joining me to discuss that trend is Alex Bryan--he's an analyst in Morningstar's manager research group.

Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: You wrote an article in the most recent issue of Morningstar ETFInvestor, where you looked at some of these new multifactor ETFs that have been hitting the market. Before we get into what a multifactor ETF is, I'd like you to start by talking about what a factor ETF is and what factor-based investing is?

Bryan: Factor-based investing is basically targeting securities with characteristics that have historically been associated with better returns, lower risk, or some combination of the two. These characteristics could be anything from low valuations--meaning value stocks--to high profitability, strong recent price performance or momentum, or low volatility or relative safety. These are all active strategies that have been successful in the past. Although a lot of these factor ETFs that try to take advantage of these different characteristics are index based, they are in fact making active bets, and investors should be comfortable with those.

Benz: The multifactor ETFs take that concept one step further in that they bundle some of these factors together. What's the virtue of doing that and what's the thought behind combining multiple factors into a single product?

Bryan: Even though each of these individual characteristics has been associated with better long-term performance, each of them can go through extended periods of underperformance--and they have. So, if I'm an investor and I'm really convinced that value investing is the way to go, if I have a long enough time horizon--like 20 or 30 years--that may pay off, but we're now in a long stretch where value stocks have been out of favor. So, if I'm an investor, that fact can make that strategy very difficult to stick with through an extended drought. And that's not just true of value; it's true of any of these factors that we talk about.

So, the basic idea is that, by combining these factors into a single portfolio, we can diversify our risk of underperforming because each these factors tends to work best at different times. So, if I put them together in a portfolio, I reduce the risk of going through an extended period of underperformance. That can make that portfolio easier for me to own if I'm a risk-averse investor, as most are.

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