Multi-factor ETFs
Introduction
A multi-factor ETF is an ETF that follows an index that screens its potential holdings using two or more investment factors. For example, if an ETF follows a small cap, high dividend, low volatility index, it is considered to be a multi-factor ETF because it is screening on three factors: size, dividends and volatility.
Here is a count of the multi-factor ETFs in our database
Multi-factor ETFs are complex
The number of different approaches is staggering
It is very difficult to compare multi-factor ETFs because they use an amazingly different combinations of factors. There are nine common investment factors:
- Size
- Value
- Momentum
- Quality
- Growth
- Volatility
- Dividends
- Investment
- Fundamental factors like debt to equity
Not only do they use different combinations of factors but they also weight their holdings differently (equal weight versus fundamental weight versus market capitalization weighting). And they are selecting stocks from different capitalization sizes (large cap stocks versus mid cap stocks versus small cap stocks).
There also isn't any agreement on what the factors really are. The "quality" factor is one of the most commonly cited factors. But there is no agreement as to what makes up the quality factor. It usually measures how profitable a company is, but there are ten different approaches to measuring a company's profitability. Some indexes use net income, some use "operating earnings", some use return on equity, some use free cash flow, etc... So it is not an exaggeration to say that no two multi-factor ETFs are really alike!
No one is precisely following academic research
The most famous academic factor models, such as the Fama French 5 factor model, use a combination of factors that don't really match up against the combination of factors used by the multi-factor ETFs. Fama French used as factors size (small cap), value, high operating earnings and low investments (low growth in total assets on the balance sheet). We're not sure that any multi-factor ETFs match up to that. Similarly, Hou Xue and Zhang used as factors size (small cap), high return on equity, and low investments (low growth in total assets on the balance sheet). We're not sure that any multi-factor ETFs match up to that.
Does multi-factor investing work?
There are plenty of people who still question whether smart beta and multi-factor ETFs are really a good idea. The ETF industry has become very competitive, and as a result, the fees associated with many non-smart beta ETFs have become very low. You can buy an ETF that tracks the S&P 500 Index and pay very little in fees. For example, the fees associated with IVV, the iShares Core S&P 500 Index Fund ETF, are currently 0.04%. The low fees make it very tempting to just build a stock portfolio using IVV, or any of the other market-cap index based ETFs that have low fees.
It is also open for debate whether it is possible to build a multi-factor index that will successfully outperform the market over long periods of time. The only investment factor that clearly has a long-track record of outperformance is probably the size factor - i.e. small cap stocks generally outperform large cap stocks over long periods of time. But again, you can buy an ETF that tracks the S&P Smallcap 600 Index and pay very little in fees. The fees associated with IJR, the iShares S&P SmallCap 600 Index Fund ETF, are currently 0.07%.
So it is by no means an unreasonable position for long-term investors to ignore multi-factor ETFs and just buy a simple stock portfolio of IVV and IJR and pay very little in fees. There are no guarantees of course, but IJR will probably outperform most large cap, multi-factor ETFs over the next 15 years.
We tend to take a middle ground in the debate. We don't think investors should abandon cheap ETFs like IVV and IJR in favor of multi-factor ETFs, but we also think there are some multi-factor ETFs that are worth while.