This Fund Leans Into Performance-Based Factors

This fund seeks to maximize its aggregate exposure to stocks with attractive value, momentum, small size, and quality characteristics, while matching the risk level of its parent index, the MSCI USA. To achieve this, the fund constructs a portfolio using an optimizer that balances each stock's targeted factor characteristics against its risk. This can lead to inconsistent factor loadings through time because the optimizer shrinks its allocation to factors as their volatility increases. By targeting factors with low correlations to each other and constraining its stock and sector weightings, this strategy should diversify risk. But the optimization process is complex and opaque, which makes it difficult to assess how the portfolio will shake out.

This strategy has a stronger value and mid-cap tilts than its multifactor peers. It aggressively pursues its targeted factors and has a higher active share than many of its multifactor peers. This strategy further strengthens its style tilts by considering its holdings' aggregate factor exposures rather than mixing stocks that score well on any one factor. A mixing approach can wash out factor exposures. This approach should be greater than the sum its parts. Although it lands in the large-value Morningstar Category, the index has performed more like a mid-cap value fund.

This strategy launched in April 2015, so it has not established a meaningful record. From inception through January 2017, the fund outpaced the MSCI USA Index and the large-value category average by 0.4% and 1.5%, respectively, with similar risk.

Fundamental View This fund targets the value, momentum, small size, and quality factors, which have historically been associated with better performance in nearly every market studied over long time horizons. Each factor that this fund targets has a reasonable risk-based and/or behavioral explanation that has been extensively tested in academia and practice.

For the value effect, the risk-based explanation seems best. Value stocks tend to have less-attractive prospects than their more-expensive counterparts and may offer higher expected returns as compensation for their higher risk. But behavioral biases could also contribute. Investors may extrapolate past growth (or lack thereof) too far into the future, which may cause the market to undervalue slower-growing value stocks.

Behavioral biases are likely the best explanation for momentum. Stock prices adjust more slowly than they should because investors initially under-react to new information. Also, investors are prone to following price trends, which push stock prices away from fair values, potentially leading to the long-term reversals associated with the value effect. Momentum complements the value factor well because one tends to work when the other doesn't.

The most accepted size premium explanation is risk-based. Smaller stocks are less profitable, have less-established competitive advantages, and are more sensitive to the business cycle than their large-cap counterparts. Potential higher returns reward this higher risk over the long run. Conversely, quality is a more defensive factor. A possible explanation for its success is that investors may not appreciate the long-term sustainability of highly profitable firms' earnings power, which can lead to undervaluation, even though these stocks don't necessarily trade at the lowest valuations.

While these factors have strong long-term track records, each can underperform the broad market for extended stretches. Combining them in a portfolio diversifies risk and helps investors stay invested. By integrating stocks' aggregate scores across the four targeted factors, the strategy can achieve deeper tilts toward the intended factors. The strategy scores stocks' value and quality factors within each sector rather than across sectors. This makes sense as the stocks share attributes such as accounting standards, business risks, and valuations.

This strategy equally weights a composite of three value metrics (forward price/earnings, enterprise value/operation cash flow, and price/book) within each sector to score stocks. Quality scoring follows a similar approach, where three equally weighted metrics (return on equity, debt/equity, and earnings variability over the past five years) form a quality composite score for stocks within each sector. The fund measures momentum across sectors using 12- and six-month relative price strength and "historical alpha." Both relative-strength measures incorporate a one-month lag. Historical alpha measures each stock's excess returns over the past two years after adjusting for its market risk.

Portfolio Construction This fund replicates the MSCI USA Diversified Multiple-Factor Index, which seeks to maximize the portfolio's aggregate exposure to the value, momentum, small size, and quality factors, which have all been associated with long-term market-beating performance. And it keeps risk within striking distance of the MSCI USA Index's. This diversified strategy earns a Positive Process Pillar rating.

This fund selects its holdings from the MSCI USA Index, which includes stocks representing the largest 85% of the U.S. market. To achieve the intended factor tilts and match its parent index's risk level, this fund optimizes its holdings based on their factor exposures and correlations with each other using a Barra risk-modeling tool. The optimizer creates its portfolio using targeted risk, while applying constraints, such as limiting turnover, individual stock and sector tilts relative to its parent index, and exposure to nontargeted factors. This approach can cause the index to reduce the portfolio's exposure to a factor as its volatility increases, as it strives to keep the fund's risk in line with the parent index's. For instance, during the spring of 2008, the fund's value factor tilt decreased as that factor's volatility increased. The index is reconstituted semiannually in May and November.

Fees BlackRock charges a 0.20% fee per year for this offering, which is among the cheapest for multifactor strategies and a fraction of the large-value category's median fee of 0.78%, supporting the Positive Price Pillar rating. BlackRock launched this strategy in April 2015 with a 0.35% annual expense ratio but cut it to the current price in December 2016.

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