Don’t sleep on multi-factor ETFs

Brian Kraus, Head of Investment Consulting, Hartford Funds writes that investors are looking for new opportunities to generate alpha in this volatile market climate, but the potential benefits of multi-factor ETFs should not be ignored. 

Brian Kraus, Head of Investment Consulting and Internal Sales, Hartford Funds writes that investors are looking for new opportunities to generate alpha in this volatile market climate, but the potential benefits of multi-factor ETFs should not be ignored. 

Multi-factor ETFs may offer investors a diversified approach with lower fees and tax efficiency on average. They tend to offer risk control as well, seeking to insulate an investment portfolio from downside risk, while maintaining factor exposure that may support the portfolio on the upside. 

Low-volatility, cost-effective products, like some multi-factor ETFs, can offer investors significant long-term growth, even during periods of uncertainty. Here are three characteristics that make multi-factor ETFs worth considering.

During periods of uncertainty, market swings are inevitable, and investment advisors and portfolio allocators cannot control the day-to-day changes. However, there are elements of portfolio management that are within control – namely fees and taxes.

Multi-factor ETFs seek to deliver investors exposures to equity characteristics that may be sought by active stock pickers, but often at a fraction of the cost associated with active fund management. Furthermore, given an ETF’s construction mechanism and trading processes, multi-factor ETFs rarely pay capital gains distributions. So while market fluctuations can be detrimental to investors’ portfolios, multi-factor ETFs could potentially offer some guardrails in the form of lower upfront and year-end costs.

Retail and institutional investors alike may be motivated to trade out of what is underperforming and purchase what has been working well lately. For those practitioners who incorporate factor investing in client portfolios, recent volatility and portfolio losses may also be motivating factors to trade in and out of various equity risk factors. 

Instead of attempting to manage a series of single factor bets in a client’s portfolio, an allocator may consider implementing a more diversified and holistic strategy that can be achieved through a multi-factor solution. Multi-factor ETFs often seek to balance exposures across a diversified set of risk factors. While one or two of those factors is out of favour, the drawdown may be offset by the other factors performing positively, potentially making multi-factor ETFs more resilient to market volatility. 

Prolonged asymmetric market returns can lead to policy allocation imbalance. For instance, if stocks go down and bonds go up, and if no action is taken, the stock/bond split will look a lot different than the original intent of the portfolio. The same can be said for equity risk factors. If value continues to underperform and quality continues to outperform, and if no action is taken to rebalance exposures between the two factors, an investor’s factor allocation can be distorted, relative to the initial intent of the portfolio. 

Multi-factor ETFs, by contrast, tend to include a systematic rebalancing schedule that incorporates an index reconstitution and subsequent re-allocation of underlying holdings and factor characteristics. During volatile market environments, this rebalancing mechanism can serve as a value-driven tool to sell what has worked recently and purchase the underperforming factor, continuing to adjust in order to meet the original intent of the portfolio.

While multi-factor ETFs can be an attractive option during market volatility, it’s important to note that not all multi-factor ETFs are created equally. Many times these products are designed to overcome a certain inefficiency in a given market, but in doing so, may introduce new or exaggerated risks to an investor unintentionally. It’s important to evaluate both the offensive and defensive characteristics of a multi-factor ETF. During periods of heightened volatility and uncertainty, we would expect those strategies that strike the right balance between offence and defence emerge from a crisis in a more resilient manner than its peers.

Brian Kraus is a registered representative of Hartford Funds Distributors, LLC.