Multiple approaches to multi-factor investing
“Smart beta” ETFs have been experiencing a surge in popularity, begging the question: What’s “smart” about them, and how do they capture “beta”?
“Smart” refers to various factor strategies designed to take advantage of the inefficiencies created by traditional market cap-weighted indices. These “factors” can include the general market, momentum, value, quality, and dividend yield, to name a few of the most popular. They may be employed for any number of purposes – to look for a performance edge; to dampen volatility; to provide income; or simply to increase portfolio diversification.
“Beta” measures the sensitivity of an individual security (or ETF) to the moves of the desired factor; for example, the S&P 500 having a beta of one to represent the general market. (So, a beta of two means a stock or ETF is likely to have twice the move of the market). Taken together, the terms suggest a fund that seeks to improve on the return of a particular benchmark (the S&P 500 in this case) by having exposure to the specific factor. More broadly, factor investing could be thought of as a strategy, in which securities are selected, based on attributes associated with the likelihood of achieving a specific result or risk-adjusted return over time.
Regardless of the strategy, the smart beta concept is gaining significant traction with investors. The first single-factor ETF was launched in 2000, followed by the first multi-factor ETF in 2003.1 There’s now approximately $700 billion invested globally across more than 500 smart beta ETFs, up from about $250 billion 10 years ago, with much of the growth taking place over the last few years.1
Of course, not all smart beta ETFs are alike, even those that seek to incorporate similar factors. Identifying those factors that demonstrably add value and determining how to weight them within a portfolio are the first challenge. For multi-factor ETFs, it’s important to understand how these factors interact as well. Because they’re ETFs built on rules-based indexes, the methodologies are laid out, and the holdings are transparent.
Single-factor smart beta ETFs are often used to create a portfolio “tilt” – a change in the risk/reward profile, for example. This, in turn, can be used to further diversify a portfolio, or to express a view of the market – a belief that value will outperform, for example, or that a momentum-based strategy has the potential to improve returns over time. A multi-factor approach is used to incorporate two or more factors to provide broader coverage. For investors with little to no exposure to any factors, a multi-factor vehicle can be a good introduction to factor-based approaches and the potential positive attributes they offer.
Whether using a single- or multi-factor strategy, it is important to note that factor performance is cyclical in nature—which means that no one factor is consistently more favorable than any other. Since each factor can potentially outperform or underperform the market in any given period, diversification continues to play a key role in factor investing.
While factor investing has been popular within equities, we have also seen it being applied recently to the fixed income space. Research has shown that certain factors could work in fixed income, too, if they are backed by sound economic or behavioral rationale, for example, momentum, low volatility, quality, and income. When exploring factor investing in fixed income, investors need to pay attention to the definitions of the factors, as well as how the factors are used to construct a portfolio. Simply copying equity factor investing methodology to the fixed income space will not necessarily work, as the fixed income market is very different from equities.
1. Draper, Dan, ’10 things investors need to know about smart beta,’ CNBC.com, January 20, 2016.
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The Standard & Poor’s 500 Index (S&P 500) is an index of 505 stocks issued by 500 large companies with market capitalizations of at least $6.1 billion and is seen as a leading indicator of U.S. equities and a reflection of the performance of the large-cap universe.
Smart beta defines a set of investment strategies that emphasize the use of alternative index construction rules to traditional market capitalization based indices.
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