A Closer Look at the New John Hancock ETFs

In September, John Hancock made its first foray into the exchange-traded fund business, launching six ETFs based on indexes designed by Dimensional Fund Advisors. Dimensional is the subadvisor on these funds, an extension of its long-standing subadvisory relationship with John Hancock. In contrast to Dimensional’s mutual funds, which are only available to individual investors through a financial advisor or a platform such as a 401(k) plan, anyone can gain access to these ETFs.

The lineup includes John Hancock Multifactor Large Cap ETF JHML, which tracks an index that employs a strategy similar to

Dimensional has long criticized blind index tracking because it creates forced transactions that can increase cost. The firm has differentiated itself by applying simple investment rules but retaining the flexibility to substitute one stock for another with similar characteristics and trade patiently to reduce cost--things that indexers can’t do. At first glance, it may seem surprising that Dimensional developed index strategies. However, all of these strategies focus on large- and mid-cap stocks, where the transaction costs of rebalancing (and cost of indexing) are lower than in the small-cap arena. Dimensional also sought to mitigate transaction costs through its index construction methodology.

How it Works The large-cap fund targets the largest 750 U.S. stocks, with a buffer to reduce turnover. Dimensional applies market-cap multipliers to emphasize stocks with the targeted size, value, and profitability characteristics. For example, the firm sorts all stocks in the eligible universe (excluding REITs) by price/book within each sector and creates five buckets, each representing a fifth of the available market capitalization. Stocks in each bucket receive a different market-cap multiplier. Those in the cheapest bucket receive the largest market-cap multiplier (in this case, 1.8), stocks in the next cheapest bucket receive a slightly smaller multiplier, and so on. Those in the priciest bucket receive the smallest multiplier (1.0). As a result, the index overweights the cheapest stocks and underweights the most expensive relative to a market-cap-weighted alternative.

Dimensional applies a similar bucketing approach to sort stocks on profitability, which the firm measures as operating income before depreciation and amortization minus interest expense, over book value. It applies these sorts within each sector to mitigate large sector biases and assigns stocks to one of five buckets, each representing a fifth of the available market capitalization. Stocks representing the most profitable bucket receive the largest market-cap multiplier (1.8), and those in the least profitable bucket get the smallest multiplier (1.0).

The index emphasizes small size to a greater extent than the other two factors. Stocks are assigned to three size buckets based on their market capitalization. The smallest stocks receive a market-cap multiplier of 3.0, while the corresponding figure for the largest stocks is 1.0.

Dimensional brings these three bucketing approaches together by averaging the three multipliers for each stock. It then applies that figure to the stock’s market capitalization and weights the portfolio using the adjusted figures. However, it caps individual security weightings at 4%. As long as a stock stays within the same style buckets, changes in its price match changes in its targeted portfolio weighting, which helps mitigate turnover and reduce transaction costs.

Although Dimensional doesn’t attempt to trade on it, momentum is an important predictor of future (short-term) returns. In order to reduce unintentional bets against momentum, the index will not increase targeted weightings for stocks with the worst momentum over the most recent 11 months. This adjustment may modestly reduce turnover and improve returns. The index is reconstituted semiannually.

Is It Worth Owning? Tax efficiency is one of the biggest advantages of gaining access to this strategy via an ETF wrapper. DFA US Core Equity, which follows a similar strategy, has been fairly tax-efficient, but it has made a few capital gains distributions over the past decade. Investors in the ETF are less likely to encounter these distributions because the managers can transfer low-cost-basis shares out of the portfolio through an in-kind transaction with the fund's authorized participants.

There are some drawbacks. The ETF charges a higher expense ratio (0.35%) than its mutual fund counterpart (0.19%), and it is still very thinly traded, so it can have wide bid-ask spreads that can make it expensive to trade. And of course, investors in this fund don’t benefit from Dimensional’s flexible and patient trading approach. But once it becomes more heavily traded, JHML could be a compelling option for investors who don’t otherwise have access to Dimensional’s mutual funds. Like DFA US Core Equity, JHML offers targeted exposure to well-vetted sources of return and cost-conscious implementation.

This is a well-constructed offering, but it is joining a crowded field of multifactor strategies such as iShares FactorSelect MSCI USA LRGF (0.35% expense ratio), JPMorgan Diversified Return US Equity JPUS (0.29%), and Goldman Sachs ActiveBeta US Large Cap Equity ETF GSLC (0.09%). The John Hancock fund will likely have lower turnover than its peers because of its broad reach and market-cap multiplier approach, which allows market prices to drive changes in portfolio weightings. In contrast, its peers ignore market prices and weight their holdings either by the strength of their style characteristics or with a more complex portfolio optimizer, which will likely require higher turnover at reconstitution. However, the fund’s higher expense ratio slightly detracts from this advantage. And it may not offer the highest returns because it does not target stocks with positive momentum as GSLC and LRGF do.

There is a risk that the returns to these strategies could diminish with the growth in the popularity of factor investing. But to the extent that investors are swayed by fear and greed, or require risk premiums for holding stocks with characteristics such as low valuations, these strategies may continue to pay off.

While the large-cap multifactor strategy has merit, long-term investors should be wary of John Hancock’s four multifactor sector funds. There is no reason to believe the approach should work better when restricted to a single sector, and investors in these funds sacrifice diversification. Tactical sector investing might make sense for some, but not for the type of long-term investor Dimensional targets. Dimensional developed these strategies at the request of John Hancock.

Disclosure: Morningstar, Inc.'s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.