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ETF Specialist

Balancing Targeted Bets With Diversification

This multifactor ETF sacrifices transparent portfolio construction for deeper factor tilts.

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Multifactor funds earn their keep by diversifying bets across factors that enhance portfolio return or reduce its risk. Similar to stock market sectors, different factors perform better than others during the market cycle.  IShares Edge MSCI Multifactor USA ETF (LRGF) is a good pick to spread factor bets among U.S. stocks. The exchange-traded fund's low fee and stringent risk management should contribute to its edge over the long run, but it has a short live track record. It earns a Morningstar Analyst Rating of Bronze.

LRGF seeks to maximize its exposure to stocks with attractive value, momentum, small size, and quality characteristics while matching the risk level of the market-cap-weighted MSCI USA Index. This strategy has delivered stronger value and mid-cap tilts than many of 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 LRGF's return potential. Although it lands in the large-cap value Morningstar Category, it has performed more like a mid-cap value fund.

LRGF uses an optimizer to construct its portfolio that weighs each stock's targeted factor characteristics against its contribution to portfolio risk. This approach shrinks its allocation to factors as their volatility increases. This approach increases the ETF's cumulative factor exposure while keeping its risk in line with its starting universe. By targeting factors with low correlations to each other and by 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 launched in April 2015, so it has not established a meaningful live track record. From inception through January 2019, LRGF outpaced the large-value category average by 1.3% annualized but trailed the MSCI USA Index by 1.5%.

Fundamental View
LRGF 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 ETF 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.

LRGF 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 advantage 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 ETF 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 it from taking large uncompensated bets but obscure its portfolio construction process.

LRGF uses an optimizer to maximize its factor tilts while 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 ETF's exposure to nontargeted factors such as dividend yield and liquidity. These risk controls likely reduce its style purity. The resulting portfolio of its complicated construction process ends up in the large-value category.

Although this ETF lands in the large-value category, it may behave differently than the Russell 1000 Value Index, the category benchmark. The average market capitalization of LRGF's holdings measures half that of the category index. This smaller size orientation stems from its explicit targeting of smaller stocks and from breaking the link between market cap and its weightings. Because LRGF anchors its sector weightings to a broad market-cap-weighted index (the MSCI USA), its sector weightings differ substantially from the Russell 1000 Value. As of this writing, its utilities sector weighting was twice as large as the Russell index's, while its telecommunication-services exposure measured half of the index's.

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

LRGF 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 stock's targeted factor scores, the strategy can achieve deeper tilts than if it mixed separate factor portfolios together. The strategy updated its factor metrics in May 2018 to align with MSCI's most recent risk model, but these new measures shouldn't materially impact the portfolio.

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 index that LRGF tracks decreased its value factor tilt in the spring of 2008 as the risk of value increased.

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-cap value category's median fee of 0.75%, supporting the Positive Price Pillar rating. However, there are even cheaper index alternatives.

During the past year through January 2019, LRGF lagged its underlying benchmark by 0.16%, less than its annual expense ratio.

 Goldman Sachs ActiveBeta U.S. Large Cap Equity (GSLC) (0.09% fee) is the cheapest U.S. multifactor strategy and earns an Analyst Rating of Bronze. It targets stocks with low valuations, strong momentum, high profitability, and low volatility, but instead of viewing its holdings' factor exposures holistically, it treats each factor as its own sleeve. This leads to diluted factor tilts but offers a more transparent process. This ETF selects stocks from an index similar to the S&P 500 and takes modest bets relative to its starting universe.

Bronze-rated  AQR Large Cap Multi-Style (QCELX) (0.44% fee) uses an integrated approach to target stocks with strong value, momentum, and quality characteristics. Like LRGF, this strategy uses an optimizer to build its portfolio and applies stringent selection criteria, which allows for deeper factor tilts at the expense of transparency. It assesses value and quality scores intrasector and limits sector bets versus the Russell 1000 Index. This strategy is only available to individual investors through financial advisors.

 DFA US Core Equity 1 (DFEOX) (0.19% fee) offers broader exposure to the U.S. stock market than most of its multifactor peers. It tilts toward stocks with low valuations, small size, and high profitability but doesn't target stocks with strong momentum. This Silver-rated strategy ties its holdings' weightings to their market cap, which helps keep turnover low. It is only available to individual investors through select financial advisors and platforms. Investors who don't have access to this strategy might consider John Hancock Multifactor Large Cap ETF (JHML) (0.35% fee), which tracks a DFA-managed index and follows a similar approach.



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Adam McCullough does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.