Understanding Multifactor Investing

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. 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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Benz: Just to play devil's advocate: Say I bundle together multiple factors within the U.S. equity universe, for example, is there a risk that I'm going to end up with a product that behaves a lot like a capitalization-weighted index but I'm paying more for it?

Bryan: Absolutely. That's a good point. A lot of times when you put these different types of strategies together, you are going to start to look a little bit more like the market. Certainly, tracking error--or the difference in performance between the multifactor strategy and an index--is going to become smaller as we start to add more factors in. So, that's both good and bad. It's reducing my risk of underperformance, but it's also potentially reducing my potential for outperformance. But it's important to remember that when we talk about multifactor ETFs, there is such a big range of different types of strategies. Some take very modest bets where you are going to perform more like the market but will have a smaller risk of underperformance; then you have other funds that are taking more aggressive style tilts. There, even though you are combining several different factors together, you can still have performance and a portfolio that may look very different from the market.

It's important to bear that in mind. But as you mentioned, costs still matter. The higher the fee you're paying, the higher the hurdle that these new strategies have to overcome. So, investors should still be mindful of the costs they are paying--making sure that they are getting value for what they are paying.

Benz: I want to drill into some of the specific funds that you outlined in your article--some of the specific strategies that you looked at. Let's start with one fund that you talked about, which is a new Goldman Sachs exchange-traded fund. You say this is an example of one of the multifactor funds that employs some more-modest style bets.

Bryan: This is the Goldman Sachs ActiveBeta US Large-Cap ETF (GSLC), and it charges 9 basis points, which is about the same price that the SPDR S&P 500 ETF (SPY) charges. That's with an expense waiver; but even without the waiver, it's still pretty cheap. But basically the way this fund works is it starts with the 500 largest U.S. stocks and basically tilts toward stocks with higher profitability, lower valuations, stronger momentum or recent price performance, and lower volatility. But it's not screening out that many stocks.

So, even though it has a starting universe of 500 stocks, this portfolio owns more than 430 of those names. It's just slightly overweighting and tilting toward the stocks that have those characteristics and underweighting stocks with the opposite characteristics. So, the tracking error on this portfolio relative to the S&P 500 is supposed to be pretty small. In fact, I was talking with a manager at Goldman Sachs who said the expected tracking error on this strategy would be around 2%, which is not very much. But if I'm an investor and I don't want to take a big bet--if I want to use this as a core holding--it's certainly a very compelling option for that. I may not hit any the home runs with this fund; but if I'm looking for a little bit of outperformance without paying a whole lot extra, it's a good option for that.

Benz: Another fund that you mentioned that has more-aggressive factor tilts embedded in it is an AQR fund. This one is not an ETF--it's an active fund, really. Let's talk about that product and what sorts of style tilts it's employing.

Bryan: This is the AQR Large Cap Multi-Style Fund (QCELX). Even though it's not an ETF and it doesn't track any index, it's a rules-based strategy. What it does is, at the end of each month, it basically targets stocks with low valuations, strong momentum, and high profitability. It starts with a universe of the 1,000 largest U.S. stocks by market capitalization. It basically targets stocks representing the 25% of the market with the strongest style characteristics as measured by those three different factors. So, that's a more-aggressive style tilt than the Goldman Sachs fund, which is blanketing most of the large-cap market. This is specifically going after the stocks that are the strongest value, the most profitable, and have the best momentum. And it rebalances every month, so it's aggressively going after these style tilts. That's going to create higher turnover, but it's going to give you a pure exposure to each of these style characteristics. So, if value is in favor and momentum is in favor, this fund should benefit from those stylistic tilts to a greater extent than the Goldman Sachs fund because it is more aggressive in terms of its exposure.

Benz: I don't always think AQR is the cheapest provider, but they seem to do a very good job on some of their strategies. How does this fund stack up in terms of its expenses?

Bryan: Its net prospectus expense ratio is 47 basis points. So, it's a bit more than the Goldman Sachs fund, but it does give you greater potential for outperformance. Because it's not tracking an index, this fund--along with a lot of AQR strategies--gives the manager some flexibility to balance transaction cost against the benefits of trading when they go to make their buy/sell decisions. So, they don't have to follow the rules mechanically. If the transaction costs are going to outweigh the benefits of making a trade, AQR will hold off on that, whereas the Goldman Sachs fund--because it's based on an index--is going to blindly replicate that index regardless of the cost of doing so.

Benz: The last fund you wanted to highlight is a JPMorgan fund. You said that it's appropriate for investors in search of a low-volatility take on the U.S. equity market.

Bryan: That's right. This is the JPMorgan Diversified Return US Equity ETF (JPUS). This fund basically provides broad exposure to the U.S. large-cap market. It does filter out stocks that have the weakest momentum, value, and profitability characteristics; but by and large, it's providing broad exposure to the market. The biggest difference between this fund and the others that we talked about is how much it emphasizes stocks with low volatility. It weights its holdings based on the inverse of their volatility, such that the least-volatile stocks get the largest weightings in the portfolio.

This gives it a bit of a defensive posture that can allow it to weather market downturns better than some of its peers and some of the other multifactor strategies that we talked about--and better than the broad U.S. large-cap market. So, if I am a more risk-averse investor, this may be a compelling option for me because it should weather market downturns better than most and it could still potentially benefit from some of those modest style tilts that it's making.

Benz: And there have been some academic data to indicate that low-volatility strategies tend to outperform or certainly perform in line with the broad market over time.

Bryan: They offer a more-favorable risk/reward trade-off--that's for sure. Now, with this type of strategy, it wouldn't be reasonable to expect it to necessarily keep up with the market during a strong rally. But if you have a long enough time horizon, the risk/reward trade-off, I think, is going to be more favorable here than with a broad market-cap-weighted fund.

Benz: If I'm thinking about any such product, how do I employ it within my portfolio? Do I maybe hold a broad capitalization-weighted index as well as one of these products or is the goal that this would supplant my cap-weighted index fund?

Bryan: I think it depends on your goals. But the way that I like to think about these strategies is as a substitute for your traditional actively managed strategies, because these are all making active bets in one way or another. So, if you're looking to use these types of strategies in your portfolio, I think it makes sense to use them as a substitute for traditional active management.

Now, you could use these as core holdings. So, the Goldman Sachs fund that we talked about earlier could certainly be a replacement for an S&P 500 fund, if you're looking to potentially add a little bit of outperformance over the long term. There is no guarantee of that, but you're paying a very modest fee for that potential outperformance. I think that's a reasonable trade-off. Again, the way I would think about this is if I have an active manager--or if I have a certain portion of my portfolio allocated to active managers--I think it would make the most sense to use this in that sleeve of the portfolio.

Benz: And you may be able to lower the costs of that active management as well.

Bryan: Absolutely. These funds do charge a little bit more, on average, than traditional market-cap-weighted index funds; but they do tend to be a bit cheaper than traditional active shops.

Benz: One thing I'm wondering about, though, is any trading or tax costs associated with these strategies. Is there any reason to believe that they would be higher than is the case for, say, a cap-weighted index fund?

Bryan: Turnover is likely to be higher with these strategies. And anytime you have higher turnover, there is a greater likelihood that you may experience or recognize capital gains. Now, for the strategies that are available in an ETF wrapper, they are able to use the ETF's in-kind redemption process to manage the tax liabilities that their higher turnover can create. So, I'm not too concerned about tax efficiency for the ETF strategies. Now, that could be a greater concern with mutual funds that attempt to employ these factor-based strategies, such as the AQR fund that we talked about. But AQR does have a tax-managed version of the strategy that may be more appropriate for taxable accounts.

Benz: Another thing you say is important to keep an eye on is that some of these funds do have some sector bets in place that are an outgrowth of the multifactor strategies that they're using. So, investors need to keep tabs on that, too.

Bryan: That's absolute right. Although these strategies are targeting certain factor exposures, they may introduce some unintended sector bets that investors may not realize. So, it's important to keep an eye on the sector allocations to make sure that you're not getting any risk exposures that you're not comfortable with. Anytime you have a large sector overweighting or underweighting relative to the market, that could be a source of risk that could drive performance, either good or bad, depending on how the market is performing in that period. But it is also important to keep in mind that, again, each of these strategies is making an active bet. So, you should be comfortable with that before you decide to jump on the bandwagon with these.

Benz: Alex, interesting crop of new funds. Thank you so much for being here to share your insights.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.