Multi-factor ETFs: adding the “free lunch” to factor investing
In perhaps his most famous quote ever, Harry Markowitz called diversification “the only free lunch in finance.” For investors, the power of diversification is nothing new, and every advisor is well aware of the value of diversifying holdings within any (and every!) portfolio. That means diversifying asset classes, industries, sectors and, of course, individual securities. For the growing number of advisors who are using the power of ETFs to bolster their portfolios, the next step is to apply the wisdom of diversification to the universe of factor investing.
In general, factor investing focuses on a specific investment’s underlying risk profile and the factors that drive its returns. Though the list seems to be growing every day, some of the most common factors used are Value, Size, Quality, and Low Volatility. One thing that makes factor investing so attractive is that it can be applied to any type of asset. Stocks, yes, but also fixed income, alternatives, currency, and commodities. Factors make it possible to identify assets that offer specific benefits for a portfolio.
For advisors, the marriage of factor investing and ETFs has been a match made in heaven, bringing together the well-known advantages of ETFs—tax efficiency, intraday liquidity, and transparency—with the ability to single out a single characteristic and easily add it to a core portfolio. The result: today there are more than 600 smart-beta ETFs on the market with more than $150b in invested assets.
And yet, despite the fast-growing menu, the majority of ETFs in use today are traditional, single-factor ETFs. In fact, in a recent poll by ETF Trends, nearly two-thirds of advisors surveyed responded that they are using single-factor ETFs alone as part of their overall investment strategy. The problem? Single-factor ETFs lack the one thing that can offer every investor that famous “free lunch”: diversification. That’s precisely where multi-factor investing comes to the rescue.
It’s no surprise that single factors—like single stocks—are highly cyclical over time. This makes knowing when to apply any given factor just as challenging as knowing how to time the market in general. A multi-factor approach helps wipe away that challenge. By combining multiple factors into a single ETF, it is much easier to create a diversified solution that seeks to enhance returns over time. This is true not only because of the cyclical nature of the market itself, but also because most factor returns are not highly correlated—a fact that adds even greater diversification and the potential for higher returns.
Looking at the performance of 7 factors over a 10-year period, we used an equally weighted methodology and compared total returns to the S&P 500 during the same period.
Source: Morningstar, as of 12/31/17. Analysis conducted from 12/31/2004-12/31/2017. Optimum Factor Weights (Max. 25%) apply a 25% maximum weight to any one factor when forming an optimized portfolio. Equal Factor Weights apply an equal weight to each factor when forming an optimized portfolio. The Market is represented by the S&P 500 Index. Standard deviation is a measure of the dispersion of a set of data from its mean. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
As you can see, the equal-weighted multi-factor approach (represented by the gray circle) delivered a higher annualized rate of return at less risk, as measured by standard deviation, than the S&P 500 Index. As illustrated above, when a max cap-weight of 25% is applied and when factors were combined into one strategy, the potential return increased dramatically (represented by the blue circle). What the data revealed was that an equal-weighted multi-factor investing approach had the potential to deliver a much more efficient portfolio—higher return with less risk—than a single-factor approach.
To anyone who has watched market movement over time, that outcome may seem overly logical. Historically, different factors drive higher returns in different market environments. Just look at one factor, momentum, as an example. In 2017, momentum was the best performing factor. In 2016, it was the worst. In fact, over the past decade, momentum’s pendulum swung from one extreme to the other over and over again.
Single factors have been highly cyclical from year to year, and timing can be a difficult endeavor. Combining multiple factors creates a more diversified solution to potentially enhance returns over time.
Source: Morningstar, as of 12/31/17. The quality factor is represented by The Russell 1000 Quality Factor Index which is an index representative of the Russell 1000 ranked by quality. The dividend factor is represented by The S&P 500 Dividend Aristocrats Index which is an index of companies based on the S&P 500 that have raised dividends each year for the last 25 years. The high beta factor is represented by The S&P 500 High Beta Index which measure the performance of 100 constituents in the S&P 500 that are most sensitive to changes in market returns. The low volatility factor is represented by The S&P 500 Low Volatility Index which measures the performance of the 100 least volatile stocks in the S&P500 Index. The momentum factor is represented by The S&P 500 Momentum Index which measures the performance of securities in the S&P 500 Index that exhibit persistence in their relative performance. The value factor is represented by The S&P 500 Value Index which measures the performance of large-capitalization value sector in the U.S. equity markets. The size factor is represented by The S&P 600 Index which measures the small-cap segment of the U.S. equity market. Past performance is not a guarantee of future results. It is not possible to invest directly in an index. Diversification does not guarantee a profit or protect against a loss.
Considering this constant rotation, the problem of single-factor investing is clear: if you guess wrong, risk increases dramatically. While those who time it right are able to reap the rewards, poor timing can be absolutely devastate a portfolio.
Enhancing multi-factor investing
Clearly, a disciplined approach to combining factors and applying them in any market cycle is key to helping manage risk and achieving the potential for increased returns that is every investor’s goal.
The menu of multi-factor ETFs is growing at a rapid pace, giving investors more choice than ever. By combining the diversification of multi-factor investing, the advantages of an ETF, and the discipline of the Chaikin Power Gauge, investors can finally seek the “free lunch” they’ve been hoping for—all at a lower risk and with more potential for growth than ever before. Try the Chaikin Power Gauge today.
Diversification does not ensure a profit or protect against a loss in a declining market.
As with all investments, there are certain risks of investing in the Fund. The Fund’s shares will change in value, and you could lose money by investing in the Fund.
A smart Beta ETF is a type of exchange-traded fund that uses alternative index construction rules instead of the typical cap-weighted index strategy, in a transparent way. It takes into account factors such as size, value and volatility.
CSML: The Underlying Index may not be successful in replicating the performance of its target strategies. The Underlying Index seeks to provide exposure to small-cap equity securities that are expected to outperform peers, based upon a quantitative multi-factor model. There is no guarantee that the construction methodology of the Underlying Index will accurately provide exposure to equity securities that outperform their peers. Furthermore, an investment in a security that outperforms its peers may still lose money.
Stocks of small-cap companies may be subject to greater price volatility, significantly lower trading volumes, temporary illiquidity, cyclical, static, or moderate growth prospects, and greater spreads between their bid and ask prices than stocks of larger companies. Stock prices of small-capitalization companies may be more volatile than those of larger companies and, therefore, the Fund’s share price may be more volatile than those of funds that invest a larger percentage of their assets in stocks issued by mid-or large-capitalization companies. Stock prices of small-capitalization companies are generally more vulnerable than those of mid-or large-capitalization companies to adverse business and economic developments. Securities of small-capitalization companies may be thinly traded, making it difficult for the Fund to buy and sell them. In addition, small-capitalization companies are typically less financially stable than larger, more established companies.
CLRG: The Underlying Index may not be successful in replicating the performance of its target strategies. The Underlying Index seeks to provide exposure to large-cap equity securities that are expected to outperform peers, based upon a quantitative multi-factor model. There is no guarantee that the construction methodology of the Underlying Index will accurately provide exposure to equity securities that outperform their peers. Furthermore, an investment in a security that outperforms its peers may still lose money.
Investments in common stocks and other equity securities are particularly subject to the risk of changing economic, stock market, industry, and company conditions and the risks inherent in the portfolio managers’ ability to anticipate such changes that can adversely affect the value of the Fund’s holdings. Opportunity for greater gain often comes with greater risk of loss.
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