A Multifactor Strategy That Effectively Manages Risk

Fund providers have launched a number of multifactor strategies over the past several years. These funds try to diversify their factor exposures and span a wide range of approaches from simple to complex. No two are alike, and nuance often makes the difference between good and bad. Hartford Multifactor Developed Markets ex-US ETF RODM lands on the good side. It looks for stocks with a strong combination of value, momentum, and quality characteristics. Then it adds a low-volatility strategy on top to help control risk. It earns a Morningstar Analyst Rating of Silver.

This strategy starts with all large- and mid-cap stocks listed in 22 developed markets outside of the United States. It scores each one on the strength of its value, momentum, and quality characteristics and combines them into an overall score for each stock. Half of each stock’s composite score is based on its valuation. Another 30% is tied to its momentum, with the final 20% determined by its profitability. An optimizer then selects and weights stocks to maximize the portfolio’s exposure to names with strong overall scores while limiting risk. It uses each stock's historical standard deviation and correlation with others to build a portfolio with 20% lower expected volatility than the market. This is an effective way to improve risk-adjusted performance because there isn’t a strong relationship between risk and return among individual stocks.

The portfolio holds stocks with an attractive combination of value, momentum, and quality characteristics, but its emphasis on the value factor eats into its factor diversification. It should tilt toward stocks trading at lower valuations, which can cause it to underperform the index when value is out of favor.

While the portfolio leans toward the value side of the Morningstar Style Box, the fund’s low-volatility tilt drives most of its active risk. It should behave like a low-volatility strategy most of the time, outperforming the MSCI ACWI Ex USA Index when the market declines and underperforming during market rallies. It should also push the portfolio away from riskier stocks and toward those that are more stable.

So far, the fund has exhibited lower risk than the market. On average, it was less sensitive to market movements while its standard deviation was 9% lower than the MSCI ACWI Ex-USA Index from its launch in February 2015 through August 2020. That helped it beat the benchmark on a risk-adjusted basis over that period.

Process This strategy targets stocks with a favorable combination of value, momentum, and quality characteristics, while cutting back on risk. Cutting back on risk should improve its chance of outperforming. Each of these three factors has a good chance of outperforming the MSCI ACWI Ex-USA Index over the long run, while reducing risk can improve risk-adjusted performance. It earns an Above Average Process Pillar rating.

This fund tracks the Hartford Risk-Optimized Multifactor Developed Markets (ex-US) Index. It starts with all large- and mid-cap stocks listed in 22 developed markets outside of the U.S., including Canada. The strategy scores each stock on profitability (gross profits divided by assets), momentum, and value. It then combines these individual scores into an overall composite score. Each stock's value score makes up half of the composite score, while momentum and profitability represent an additional 30% and 20%, respectively. The fund’s heavy emphasis on stocks with low valuations makes it more dependent on the value factor’s performance.

An optimizer then selects and weights stocks, trying to maximize the fund's exposure to those with high composite factor scores while targeting 20% lower volatility than the market. The optimizer keeps sector and country weights within 2% of their weight in the market to limit unintended bets on these segments that may not be rewarded.

The index rebalances semiannually in March and September. The committee that oversees the index limits one-way turnover around 30% at each rebalance, though it may allow a little more to emphasize stocks with high composite factor scores.

Portfolio This process produces a dynamic portfolio that can change its factor exposure over time. While value accounts for half of each stock's factor score, the fund's exposure to quality and momentum tend to increase as they become less volatile. For example, the portfolio favored stocks with strong momentum between September 2016 and March 2018--a period when the momentum factor was stable in many markets around the world. Since then, it has drifted toward the large value segment of the Morningstar Style Box, but it still lands in the foreign large-blend Morningstar Category.

This strategy cuts back on risk and goes beyond simply owning stocks with low standard deviations. Volatile companies from the materials sector, like Fortescue Metals Group, have found themselves among the portfolio’s largest positions because their low correlations with others help reduce the portfolio’s overall volatility.

This well-diversified portfolio holds more than 400 stocks, and its 10 largest holdings typically account for 25% to 30% of the fund’s assets. The optimizer’s constraints have kept the fund’s sector and country weights close to those of the MSCI ACWI Ex-USA Index. As of August 2020, the healthcare and financial sectors were the largest, with each accounting for roughly 15% of the portfolio.

Performance The strategy was effective at reducing volatility over most of its life. Its standard deviation was 9% lower than the MSCI ACWI Ex-USA Index from its launch in February 2015 through August 2020. That helped it mildly outperform that index by 7 basis points annually over that period. For the most part, it has been less sensitive to market movements. For example, the fund beat the benchmark by 2.5 percentage points during the second half of 2018, when many global markets went through a correction. However, it underperformed the index by 4.1 percentage points during 2019's market rally.

However, the fund’s factor exposures can increase its risk from time to time. It started overweighting value stocks at the March 2018 rebalance and continued to have a value orientation through December 2019. That caused the portfolio to be riskier than the market during the coronavirus sell-off in first quarter of 2020. It lost about 1.4 percentage points more than the benchmark over those three months, while its standard deviation was slightly higher.

The portfolio managers have skillfully tracked this fund’s target index. The portfolio lagged its bogy by 5 basis points annually over the trailing three years through August 2020. Conservative tax withholding assumptions embedded in the index helped the fund recover some of its fee.

People This fund is subadvised by a team at Mellon. The team has been stable and well equipped to deliver solid index-tracking performance. But this team does not stand out as one of the industry's best. It warrants an Average People Pillar rating.

Karen Wong, Richard Brown, and Thomas Durante share responsibility for this fund. Wong is head of Mellon’s index portfolio management, which includes both equity and fixed-income strategies. Brown and Durante are co-heads of equity index portfolio management at Mellon. They oversee the execution of index-tracking strategies for both domestic- and international-equity strategies. The named managers are supported by analysts who help them prepare for index changes and handling corporate actions. However, this is a small team with less specialization than larger index managers.

Wong and Brown are stepping down in late 2020 and will be replaced by Mellon veterans Stephanie Hill and Marlene Smith, respectively. Mellon is also promoting five portfolio managers to support Smith and Durante. These changes shouldn’t have a significant impact on the team’s operations or its ability to meet its index-tracking objectives.

Manager compensation is not tied to any specific index-tracking targets, but the team is subject to independent risk oversight. Hartford establishes tracking-error requirements for the managers based on market conditions.

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