Interactive Investor

Multi-factor ETFs: a beginner’s guide

9th September 2021 12:47

Tom Bailey from interactive investor

We explain the merits of investing in a range of investment styles and run the rule on three ETFs. 

The basic idea behind factor investing is that stocks with some sort of shared characteristic tend to produce higher returns over the longer term. This collective characteristic is known as a “factor”.

There are potentially dozens of factors. However, only a handful are widely accepted. These include: value, momentum, size, quality, low volatility and high yield. Stocks that can be classified as one of these, it is argued, have historically produced better performance. You can read about the main factors in more depth here.

As a result, there has been a proliferation of factor-tracking exchange-traded funds (ETFs) over the past decade or more. These ETFs will track an index that screens for stocks of specific characteristic. So, for example, Xtrackers MSCI World Value ETF 1C GBP (LSE:XDEV) takes a global index and screens for stocks deemed cheap.

However, the problem with this approach is that certain factors can perform for prolonged periods of time. Stocks with some common characteristic – or factor – also tend to be in similar sector or have a similar relation to the wider economy.

For example, from November 2020 to around March 2021, increased economic optimism saw energy, materials and financials all lead the market. This was due to increased economic optimism, thanks to the vaccine rollout – the sort of companies mentioned above tend to perform well  when economic growth picks up, usually.

However, all of these shares are also what are broadly defined as value. Compared to the rest of the market, they tend to trade relatively cheaply when the share price is compared to some other metric such as company earnings or balance sheet. Therefore, it could be said that shares that had the “value factor” performed well. Or, more accurately, the value factor outperformed, when compared to the rest of the market.

However, this has not always been the case. Over the past 10 years value has underperformed, dumbfounding many investors. For much of the 2010s, the growth factor outperformed. Growth stocks are those with faster earnings growth. There are many reasons for this. One key driver is that in periods of low economic growth, such as we saw during the 2010s, investors will pay a premium for companies exhibiting growth.

Either way, the point here is that investing in a single factor can be risky. Due to the broader macroeconomic environment, a single factor can experience sustained periods of underperformance. In many respects, factor-based investors are taking bets on the global macroeconomic outlook.

So how can the investor exploit the use of factors without opening themselves up to this risk? One solution is so-called multi-factor ETFs.

As the name suggests, multi-factor ETFs select a bunch of different factors. A multi-factor ETF will have several buckets of stocks based on several of the most widely accepted factors, such as value, momentum, smaller companies and quality.

There are of course many theoretical ways an ETF could do this. Some multi-factor ETFs will actively manage the weighting of the different factors. Others, however, choose a specific weighting to each factor and rebalance every so often. Given that there are many ETFs, however, it is perhaps best to give an idea of how they work by explaining the methodology of ones on the interactive investor platform.

Three multi-factor ETFs

First up is the iShares Edge MSCI World Multifactor UCITS ETF (LSE:IFSW). This ETF tracks the MSCI World Diversified Multiple-Factor Index. This uses the MSCI World Index as its parent index, which includes large and mid-cap stocks from across 23 developed markets. However, the index aims to maximise exposure to stocks that exhibit one of the four main factors: value, momentum, quality and low size (in terms of its market capitalisation). However, its screen also tries to prevent it gaining a higher “risk profile” that the underlying parent index.

Next is JPM Global Equity Multi-Factor ETF USD Acc GBP (LSE:JPLG). This ETF uses the FTSE Developed Index as its basis. This index is then screened for stocks based on momentum, value and quality. Each factor is equally weighted.

Another multi-factor ETF is the HSBC Multi Factor Worldwide Equity ETF GBP (LSE:HWWA). This one is slightly different from other ETFs in that it is actively managed. A professional investor will consider all of the stocks in the MSCI All Country World Index and rank them from the least attractive to most attractive based upon certain factors, such as value, quality, momentum, low risk and size. These stocks will then be selected on a quantitative basis to create a portfolio which maximises exposure to the highest ranked stocks.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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