Why use multifactor ETFs?

As investors seek protection from volatility and a potential downturn in this aging bull market, new products are being developed to take up the challenge. One is the multifactor ETF.

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Multifactor funds provide exposure to stocks with different characteristics—or factors—such as value and momentum, all in the same product.

“Multifactor sits nicely between passive and active strategies, and leverages the goals of both,” said David Stephenson, director of ETF strategy for CIBC Asset Management, in an interview last month.

The funds aim to provide less risk than passive funds that track broad-based indexes, at a lower cost than many active approaches, he said.

Multifactor ETFs take a broad index and apply a rules-based quantitative process to select securities based on the chosen factors. The five most common factors are value, momentum, size, quality and low volatility, Stephenson said.

“Once these holdings are identified, they may be equally weighted. As a result, multifactor can look different from a market-cap-weighted index and have a different risk-return profile,” he said.

“Therefore, it’s important to know what you are buying and do your due diligence just like you would when selecting an active manager.”

There are two common approaches to developing a fund, Stephenson said: integrated and isolated.

The integrated approach evaluates each stock in the universe on the targeted factors and includes those with the highest overall rating in the portfolio.

The isolated approach splits portfolios into separate sleeves, each targeting a distinct factor. “So you would have a value sleeve, a quality sleeve and a momentum sleeve, for example, and then you would combine those sleeves to create a portfolio,”  Stephenson said.

Neither approach is necessarily better than the other, he said, with advantages and disadvantages to each when it comes to managing risk and rebalancing.

Multifactor versus single-factor ETFs

Investors can also buy multiple ETFs that provide exposure to a single factor. Stephenson said the benefit of using multifactor products is that factors “are notoriously cyclical and hard to time,” so combining them in a fund has an effect similar to diversification.

For example, value has underperformed growth over the last decade. An investor holding separate funds may not have had the patience to hold onto a value fund, therefore sacrificing the diversification.

The products offer a behavioural advantage, instilling traits such as focusing on long-term returns instead of chasing short-term performance, he said.

“The active returns of single factors have low correlation to each other, so it’s unlikely multiple factors underperform at the same time. This means diversifying across multiple factors can smooth out the ride without reducing performance potential,” he said.

Multifactor ETFs can still underperform, though. If a small group of stocks is driving the market—for example, tech growth stocks—multifactor likely won’t do as well. Further, a product that equally weights stocks across its investing universe may have a small-cap bias, Stephenson said.

There’s been a surge in multifactor products, so advisors should make sure they understand how a given ETF works and how it fits into portfolios before recommending it to clients, he said. There are also a range of fees.

ETF providers including BlackRock, Manulife, Desjardins, SmartBe Wealth and CIBC have launched multifactor products.

According to National Bank’s ETF report for June, Canadian multifactor ETFs have almost $2.2 billion in assets under management, making up 2% of the ETF market. Those funds have seen outflows of $39 million, or 2%, in the first half of 2019, the report said.

This article is part of the AdvisorToGo program, powered by CIBC. It was written without input from the sponsor.