Multi-factor exchange traded funds (ETFs), or funds offering simultaneous exposure to more than one investment factor, are growing part of the of universe of alternatively-weighted funds.
Today, there are about 300 such ETFs trading in the U.S., roughly two-thirds of which are five years old or younger. These funds have approximately $65 billion in combined assets under management, up from just $2.2 billion a decade ago, according to Morningstar.
Multi-factor ETFs are not confined to domestic equities. In recent years, some multi-factor funds, including the JPMorgan Diversified Return International Equity ETF (JPIN), have outperformed rival, cap-weighted international equity strategies. JPIN, which turns four years old on Nov. 5, employs multi-factor security screening based on value, quality and momentum factors. Those are four of the five “top tier” investment factors with size being the other.
“Each of these factors has been vetted by multiple scholars and professional investors,” said Morningstar. “Many are present across asset classes and in different markets around the world. They have been subsequently tested out of sample and still pass muster. They are, in a word, legit.”
Exploring JPIN’s Utility
Broadly speaking, ex-US developed market equities have struggled against domestic equivalents over the past several years. As mentioned above, the JPMorgan Diversified Return International Equity ETF debuted in November 2014. Using 2015, the fund’s first full trading year as the starting point, we see that the MSCI EAFE Index has trailed the S&P 500 in two of the past three years and will likely do so again in 2018.
Under some circumstances, it might be reasonable to expect developed market value stocks to have offered some level of comfort over the past three years, but that has not been the case. For the 36 months ending Sept. 11, 2018, the MSCI EAFE Value Index trailed the MSCI EAFE Index by 610 basis points. During that period, the value benchmark was actually 140 basis points more volatile than the traditional EAFE Index.
That is one example of the difficulties associated with single factor investing. As the chart below illustrates, different factors lead and lag from year-to-year.
Over the course of the same three-year period, JPIN topped the MSCI EAFE Index by 240 basis points while delivering less annualized volatility.
Related: Is It Time to Think About Income?
Scores of academic studies and historical data points confirm that, particularly over longer investing horizons, stocks that are attractively valued (value factor) perform well. So do those with recently impressive performances (momentum factor). Shares of highly profitable (quality factor) companies also have the potential for solid long-term returns as do low volatility stocks.
Still, there are issues to consider with single factor strategies, including the aforementioned year-to-year fluctuations of winning and lagging factors. Additionally, constructing a “homemade” multi-factor approach by combing several single factor funds in one portfolio can lead to increased costs, reduced efficiency and the potential for tax inefficiencies.
Conversely, combining factors, as JPIN does, trims risk and while reducing the sting of periods of single factor under-performance.
“Combining stand-alone factors in a multifactor format is a sensible strategy to the extent that the factors in consideration are 1) credible, 2) well-constructed, and 3) combined in such a way as to improve the overall risk/reward profile of the resulting portfolio relative to owning any of the factors in a stand-alone format,” according to Morningstar.
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