Comparing multifactor ETFs to the popular Marvel Avengers series may seem a bit of a stretch but recent analysis from Morningstar suggests the investment strategies have more in common with the superheroes than might be immediately apparent.
In his January report Is the Sum Greater Than the Parts? A practical guide to evaluating the long-term merit of multifactor funds, Morningstar investment analyst Alan Tang describes the five factors on which these ETFS are typically based – quality, momentum, value, low volatility, and small size— as “the Avengers of the investment universe”.
Tang says that only by employing the correct combination of factors in a multifactor ETF strategy can investors hope to achieve success; much like a collective might of the Avengers is more likely to overcome a super villain than simply relying on Iron Man alone.
Tang says: “Multifactor funds marry the efficacy of factor investing with the power of diversification. Factors can work wonders on their own, but joining forces maximises their potential, much like their Avenger counterparts. Just as it’s prudent to diversify across asset classes, sectors, and global regions, it makes sense to spread one’s factor bets.”
He adds: “Individual factors are prone to sustained slumps that can test investors’ patience.”
Tang argues that much like choosing which Avenger would be most suitable in battle; investors can look at average factor characteristics of a portfolio and the number of stocks it holds, to identify the strongest multifactor funds.
“Some factors are sensible partners because they tend to excel at different times. Clever multifactor funds leverage this relationship to promote smoother performance.”
Tang gives the example of the Hartford US Multifactor ETF ROUS which selects stocks based on a composite score that weights value equally with a combination of profitability and momentum.
However, he adds: “Not all factors pull in different directions. Quality and low volatility favour similar stocks because consistently profitable companies tend to be stable operator.”
Given the plethora of multifactor ETFs available – which have attracted US$250 billion in assets since 2010 – Tang describes the universe as difficult to assess.
“Each [multifactor strategy] has its own nuances, which creates challenges in evaluating their long-term potential. A simple framework has helped Morningstar analysts sort through the clutter, and it can be applied to most multifactor funds to assess their long-term merit, regardless of the underlying complexity.”
He concludes: “The best multifactor strategies—and the easiest ones to stick with—are those that keep these incidental risks under wraps and rely on their observed factors to drive returns. Broadly diversified portfolios that span hundreds or thousands of stocks tend to fit this description the best.”
