Stay Invested With This Multifactor ETF

Fight the urge to try and time single-factor equity funds by investing in a U.S. multifactor fund. By combining individual factors that have performed well over the long haul into one portfolio, a multifactor fund can help investors stay the course when any one factor underperforms on a relative basis. In the January 2018 issue of

Morningstar ETFInvestor

, I picked

This fund seeks to maximize its exposure to stocks with attractive value, momentum, small size, and quality characteristics, while matching the risk level of its parent index, the MSCI USA Index. The fund uses an optimizer to construct its portfolio that weighs each stock's targeted factor characteristics against its risk contribution. This approach leads to inconsistent factor loadings 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 delivered stronger value and mid-cap tilts than its multifactor peers. It aggressively pursues its targeted factors and has a higher active share than many other multifactor strategies. This strategy further strengthens its style tilts by considering its holdings' factor exposures holistically rather than mixing stocks that score well on different individual factors, which can dilute the portfolio's factor exposures. This integrated approach should slightly improve the fund's return potential. Although it lands in the large-cap 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 2018, the fund outpaced the large-value category average by 2.2% annualized but trailed the MSCI USA Index by 0.3%.

Fundamental View This fund targets stocks with strong value, momentum, small size, and quality characteristics, which have historically been associated with better performance in nearly every market studied over long 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. Although these factors have strong long-term track records, each can underperform the broad market for extended stretches. Combining factors with low correlations to one another, such as value and momentum, can yield a more stable risk/return profile than any single factor fund in isolation. A smoother ride may help investors to stay the course when a particular factor experiences a dry spell.

The fund uses well-established metrics to measure factor exposures and considers how well a stock scores across all four of its targeted factors to select and assign weightings in the portfolio. Strategies that use an integrated factor combination approach like this one can achieve more-aggressive factor tilts than those that use a portfolio-mixing approach. Portfolio mixing combines separate single-factor sleeves into an overall portfolio. The advantages of portfolio mixing include transparency and that it's easier to attribute performance across factor sleeves. But these strategies run the risk of combining offsetting positions from separate sleeves that dilute factor exposures in the final portfolio. Although this fund uses an integrated approach, it includes several risk constraints that limit its tracking error to the large-cap U.S. market. These risk controls protect the fund from taking large uncompensated bets but obscure its portfolio construction process.

The fund uses an optimizer to maximize its factor tilts while the matching the risk level of its parent. The optimizer layers on constraints such as limiting turnover and individual stock and sector tilts relative to its selection universe, the MSCI USA Index. The optimizer also strives to minimize the fund's exposure to nontargeted factors such as dividend yield and liquidity. These risk controls likely reduce the fund's style purity. The portfolio that results from this complicated construction process ends up in the large-value category.

This fund may behave differently than the average fund in the large-value category. Its average holding has a market capitalization of $25 billion, which is nearly a fourth of the category average. This smaller size orientation stems from the fund's explicit targeting of smaller stocks, and from breaking the link between market cap and its weightings. Because the fund anchors its sector weightings to a broad market-cap-weighted index (MSCI USA Index), its sector weightings differ substantially from the large-value category norm. As of this writing, the fund's information technology sector weighting was twice as large as the category average, while its financial services exposure was half the category average.

Portfolio Construction The fund targets stocks with high exposure to the value, momentum, small size, and quality factors. By spreading its bets across a wide variety of stocks and adhering to strict risk constraints, this fund avoids uncompensated risks and earns a Positive Process Pillar rating.

The fund selects its holdings from the large- and mid-cap-focused MSCI USA Index. It uses a complex optimizer to maximize its desired factor exposure while considering each stock's factor exposures and correlations with each other, under a set of constraints to reduce uncompensated bets. By integrating stocks' targeted factor scores, the strategy can achieve deeper tilts than if it mixed separate factor portfolios together. The strategy uses a composite of three equally weighted value and quality metrics within a sector to measure stocks' value and quality factor loadings, respectively. The fund measures momentum across sectors using 12- and six-month relative price strength and "historical alpha." Historical alpha measures each stock's two-year risk-adjusted excess return.

The optimizer maximizes aggregate factor exposure and limits turnover, exposure to nontargeted factors, individual stock and sector tilts, and tracking error relative to its parent index. This approach reduces the portfolio's exposure to a factor as its risk increases because it strives to match the risk level of its parent index. For instance, the fund's value factor tilt decreased in spring 2008 as the risk of value increased.

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 Process Pillar rating. However, there are even cheaper index alternatives.

BlackRock launched this strategy in April 2015 with a 0.35% annual expense ratio but cut it to the current price in December 2016. During the past year through January 2018, the fund lagged its underlying benchmark by 0.22%, slightly higher than its annual expense ratio.

Alternatives

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