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17 December 2018

Choosing Multi-factor ETFs

In the final installment of our 3-part “Factors in ETFs” blog series, we look at the importance of using a consistent factor framework to help choose a multi-factor ETF based on certain exposures. To access the second post “Three top tips on picking ETF analysis tools” please follow this link.

As the trend of investors embracing factor investing continues to grow, so too does the expanse of factor strategies being sold. Over the past eight years the multi-factor ETF industry has grown to 249 funds – 42 of which made their debut in the last year and a half  – with total assets of more than $61 billion, according to Investment News.

Combined challenges

When choosing multi-factor ETFs there are many options to consider, with each option adding to the challenge of truly understanding what exposures can be hidden underneath the clever guise of a fund name or marketing strategy. For instance, a multi-factor fund promising different exposures may not be giving you a true representation of how those factors are combined. In addition, there may be a risk impact due to certain exposures to targeted factors. The real question is “What other factors are you inheriting alongside a promised mix, and are the exposures genuinely significant enough to give a fund its name?”

Relying on a fund label simply doesn’t cut it – there are far too many possibilities, and not all stated exposures make it into a portfolio.

Consistency is key

To truly understand what a fund is comprised of, we believe the use of a consistent factor framework is key. When comparing factors using such a framework, it becomes apparent that although most ETF labels align with what they promise to achieve, there are significant variations that can be observed between products sharing the same name. Some multi-factor ETFs may promote various exposures to styles, for example, Value, Quality and Low Volatility. Yet upon closer inspection there are some distinct differences in both; how much exposure they have to a stated style and other unmentioned exposures, which lie hidden, but an investor will surely receive.

To illustrate, we used the Style Analytics Skyline™ to compare two US multi-factor ETFs, both stating exposure to Value, Growth and Quality styles. We plotted the two ETFs on the Skyline (Fund ‘X’ (yellow cube) / Fund ’Y’ (red triangle) and compared them to the overall universe of US multi-factor funds in order to investigate true levels of exposure.

As can be observed, Fund ‘X’ offers deeper value exposure, higher growth, defined by 5 year earnings and sales growth, as well as high exposure to quality via return on assets that Fund ‘Y’. However, its size exposure places it at the bottom of its peer group and indicates the fund is heavily invested into smaller cap stocks. Fund ‘X’ also has less exposure to quality based on several quality factors that may be considered key to some investors, and which Fund ‘Y’ has more of.

This analysis makes it clear what exposure an investor is really buying into, when it comes to the stated factors of; Quality, Growth and Value and whether other ‘US multi-factor portfolios’ can actually offer stronger, or more desirable exposure to such factors.

 

factor analysis mutual funds comparison

As is evidenced in our example, an examination of two identical multi-factor ETFs at the factor level becomes of key importance given the variation in outcome and it was an easy and straight forward process using the right tools.

Confident choice

Factor investing is not immune from subjectivity, and ultimately the choice of factors requires a belief that those factors will continue to work in the future. Yet whatever the choice of an overall style or indeed a factor, an ETF should be expected to reflect promised, or stated exposures. A factor framework provides the tools to measure exactly that. Otherwise how can investors be sure in what they are investing in?

‘Factors in ETFs’ Factsheet

Don’t forget to download our new ETF factsheet showcasing how Style Analytics factor tools expose and look through ETFs.