Stay Diversified With This International Multifactor ETF

Diversification is essential for investment success. While it isn't a panacea, it can help reduce risk, without significantly cutting into returns. Investors have been trained to diversify across securities, regions, and asset classes, but those who decide to deviate from a market-cap-weighted benchmark should also think about diversification across investment factors. A low-cost multifactor fund like

This fund offers similar exposure to the MSCI World ex USA Index but tilts toward stocks with characteristics that have historically been associated with market-beating performance. These include low valuations, strong momentum, high profitability, and low volatility. This approach diversifies risk because each of these investment styles tends to work well at a different time. While the fund's style tilts are modest, it has a low expense ratio to match, which gives it a reasonable chance to beat the market over the long term. The fund earns a Morningstar Analyst Rating of Bronze.

The portfolio is divided into four equally weighted sleeves that each tilt toward stocks with a different targeted style. This simple approach is transparent, though a more integrated approach would probably lead to stronger style tilts. Each sleeve gives over- or underweightings to stocks from the large-cap selection universe based on the degree to which they exhibit the targeted style characteristic. The fund scales these active bets to give each sleeve a 4% target tracking error to its selection universe. Consequently, stocks with factors that introduce greater tracking error, like low volatility, receive lower active weightings. Together, these active bets partially offset one another, allowing the overall portfolio to maintain a 2% tracking-error target.

The resulting portfolio looks a lot like the MSCI World ex USA Index. It includes more than 840 stocks out of around 1,000 eligible names, with an active share of only 34%. These holdings have a smaller average market capitalization than the constituents of its parent index. However, they tend to trade at similar valuations. This is because the fund's momentum and quality sleeves pull the portfolio toward pricier names, while its value sleeve leans in the other direction.

This strategy is off to a good start. From its inception in November 2015 through June 2018, the fund beat the MSCI World ex USA Index by 1.33 percentage points annually, partially thanks to more-favorable stock exposure in the consumer defensive and healthcare sectors.

Fundamental View Stocks with low valuations, strong recent performance (momentum), high profits, and low volatility have historically offered attractive performance in most markets studied over the long term. There are reasonable economic explanations behind each effect, ranging from compensation for risk to behavioral mispricing, suggesting they will continue to work over the long run.

While each of these factors has a good long-term record, they all go through periods of underperformance. Putting them together in a portfolio diversifies risk, reducing the chance of experiencing an extended period of underperformance and making it easier to stick with the factors through their inevitable rough patches.

The fund combines these factors by holding four different portfolio sleeves that target stocks that score well on a different factor. This approach dilutes the fund's exposure to each factor because most stocks that score well on one dimension (like value) don't score well on the others (like momentum). And because each sleeve only represents 25% of the portfolio, the fund has only modest exposure to each factor. Its low tracking-error target also limits its factor bets and potential outperformance. But it should still benefit from these small tilts over time.

Combining the four factor strategies into a single portfolio helps mitigate turnover, as adjustments across the four sleeves partially offset one another. For example, if a stock in the value sleeve starts to perform well, its weighting in the value sleeve may decrease at the same time it gets a larger weighting in the momentum sleeve. The managers trade only the net change in each security's weighting. To further reduce turnover, each sleeve applies a buffer around the target active weightings for each security, so that the fund doesn't trade until the style characteristics materially change. As a result, turnover was only 23% in fiscal 2017, which is low for a strategy that incorporates momentum.

Within the value sleeve, the managers anchor the industry weightings in each region to those of the selection universe, arguing that such bets are not rewarded. They allow those weightings to float more freely in the momentum sleeve. The fund measures momentum based on performance adjusted for market risk and volatility. This gives the fund a cleaner read on strong performance that is specific to a stock that may be more likely to persist during market reversals.

The profitability (quality) and low-volatility sleeves lean toward defensive names, which should help the fund hold up a little better than the market during downturns. Both sleeves anchor their country weightings to those of the selection universe. The fund measures profitability based on gross profits/total assets, which strips out many of the expense items that may be less comparable across firms. The low-volatility sleeve measures volatility over the past 12 months, which should allow the fund to quickly detect changes in volatility.

The bets across the four sleeves aren't sized the same. The fund targets the same active risk (tracking error) from each of the four sleeves. Factors with greater active risk, like low volatility, require lower active weightings to achieve those targets than factors with less active risk, like quality.

Portfolio Construction The fund employs full replication to track the Goldman Sachs ActiveBeta International Equity Index. This index applies a transparent, turnover-conscious methodology that diversifies across four well-vetted factor strategies and limits exposure to nontargeted sources of risk. It warrants a Positive Process Pillar rating.

The portfolio is subdivided into four equal-sized sleeves, each of which focuses on a different factor, including value, momentum, quality (gross profits/total assets), and low volatility. These subportfolios start with the MSCI World ex USA Index, which covers large- and mid-cap stocks listed in foreign developed markets. Each sleeve emphasizes stocks that look attractive on its respective factor, sizing its active weightings to target a 4% tracking error to its selection universe. The value sleeve rescales its industry weightings within each region to match those of its selection universe, on the premise that value-based sector bets are not rewarded over the long term. The quality and low-volatility sleeves anchor their country weightings to the selection universe's but allow their industry weightings to float, while the momentum sleeve only applies a loose constraint on its country weightings. The fund casts a wide net, typically including at least 80% of the stocks in the selection universe. It reconstitutes quarterly and applies buffer rules to mitigate unnecessary turnover.

Fees Goldman Sachs charges a low 0.25% expense ratio for this fund, making it one of the cheapest non-market-cap-weighted options in the foreign large-blend Morningstar Category. It warrants a Positive Price Pillar rating. Over the trailing 12 months through June 2018, the fund lagged its benchmark by 13 basis points annually.

Alternatives

Bronze-rated

AQR International Multi-Style QICLX (0.60% expense ratio) applies a similar integrated approach to INTF, targeting stocks with the best overall combination of value, momentum, and quality characteristics. This is a rules-based strategy, but it doesn't track an index, giving its managers the flexibility to balance the cost of trading against the benefits.

It may also be worth considering combining individual factor funds, particularly for those who are looking for stronger exposure to certain factors. IShares Edge MSCI International Momentum Factor ETF IMTM, iShares Edge MSCI International Quality Factor ETF IQLT, and iShares Edge MSCI International Value Factor ETF IVLU all offer potent exposure to their respective factors in foreign developed markets. They all charge 0.30%.

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