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Multi-factor ETFs: too good to be true?

Multi-factor exchange traded funds (ETFs) combine several different investment styles in one product. But can you really achieve diversification with a single ETF and do they provide better risk-adjusted returns than a basic index?

In recent years ETF providers have grown more adept at injecting elements of active fund management into ETFs instead of merely replicating basic stock indices. One way of doing this has been to home in on particular styles of stock within an index, such as value or momentum. These stocks are likely to do well in certain market conditions but not others, and are designed to be short- to medium-term holdings.

Multi-factor ETFs combine several of those factors into a single ETF, on the premise that one factor will always be driving the market even if others are underperforming, meaning the ETF should deliver better returns over the long run than a single-factor ETF or a broader index.

"Multi-factor ETFs allow for factor diversification within a single ETF," says Dimitar Boyadzhiev, analyst at Morningstar. "With single factors, you have to be very aware of the clear timeframe in which you want to invest and have a very clear outlook on which factors you want to deploy for investing at any one time and which are likely to outperform."

iShares, Source and Lyxor are among the providers that have launched Multi-factor ETFs, and each uses different methods and combinations of sectors. Some factors, such as value and growth, are negatively correlated meaning they will perform differently at different times, and ideally balance each other out when used together. And other factors, such as low size and momentum, are likely to be higher-risk and perform in a more similar way at similar times.

The iShares Edge multi-factor ETFs were launched last year and aim to capture stocks that display size, quality, value and momentum attributes. The provider then caps weights and sectors in order to mimic the wider index. But so far these ETFs have not delivered more than the wider market benchmarks.

iShares Edge MSCI World Multifactor UCITS ETF (IFSW), iShares Edge MSCI USA Multifactor UCITS ETF (IFSU) and iShares Edge MSCI Europe Multifactor UCITS ETF (IFSE) only launched in September 2015, and the multi-factor indices tracked by these ETFs have returned less in the medium term than the broad MSCI World, MSCI USA and MSCI Europe indices.

With single factors, you have to be very aware of the clear timeframe in which you want to invest and have a very clear outlook on which factors you want to deploy for investing at any one time”

Over the short term, they have not delivered better risk-adjusted returns either. Over six months, the sharpe ratios - a measure for calculating risk-adjusted return - for the standard indices are all higher than their comparable multi-factor indices.

Lyxor J.P. Morgan Multi-Factor World Index UCITS ETF (LYXW) and Lyxor J.P. Morgan Multi-factor Europe Index UCITS ETF (LYX5) only launched in March this year, but since then have generated higher returns than the equivalent iShares multi-factor ETFs and original broad-based indices focused on this area.

Source's multi-factor ETFs have a longer track record and although they have also not performed much better than broader benchmark indices, they seem to offer some downside protection.

Source Goldman Sachs Equity Factor Index World UCITS ETF (EFIS) launched in 2014 and Source Goldman Sachs Equity Factor Index Europe UCITS ETF (EFIE) launched in 2015. Over one year the two ETFs have produced similar returns to the MSCI World and MSCI Europe indices. However the strategy appears to produce lower volatility and better downside protection. Source Goldman Sachs Equity Factor Index World UCITS ETF had lower volatility at 10.6 per cent than the MSCI World benchmark during the 2015 calendar year, and lost less in the worst period of performance too.

Dr Christopher Mellor, executive director at Source, says the ETFs should outperform a standard benchmark but underperform in a bull market. "The time these ETFs should do well is in a sharp sell-off and when the market is behaving normally," he adds.

However Ben Seager-Scott, director of investment strategy & research at Tilney Bestinvest, says investors should be wary of ETFs that promise to fix too many problems at once.

"The biggest issue here is that this feels like a holy grail and a free lunch," he says. "Most of the established single factors have long track records and the drivers of their returns are quite well understood. Once you start combining them it's less easy to understand the correlation between them, and that is what investors need to understand."

One way of combining factors without opting for a full multi-factor ETF is to use one of the many smart-beta ETFs that combine just two or three factors into a single product instead of four or five. A common approach is to combine low volatility with high-income stocks. PowerShares S&P 500 High Dividend Low Volatility UCITS ETF (HDLG) is an example, and over one year has beaten the S&P 500 by some margin as well as delivering a solid yield with low volatility. "Low volatility and high income make a good combination," says Mr Seager-Scott. "But if you're feeling particularly aggressive, value and momentum tend to be highly correlated and to perform well at the same time if markets are on a steep recovery."

Multi-factor ETFs are more expensive than a standard ETF, another reason to be sure that you understand what you are getting before you invest”

Multi-factor ETFs are more expensive than a standard ETF, another reason to be sure that you understand what you are getting before you invest. Source's multi-factor ETFs have ongoing charges of 0.55 per cent and 0.65 per cent and Lyxor's are available for 0.4 per cent.

"Compared with other ETFs, multi-factor ETFs, and growth and fundamentally-weighted strategies, are at the high end of strategic beta pricing so investors should expect to pay relatively high fees for them," says Mr Boyadzhiev.

Despite this, ETFs using a combination of minimum volatility, yield and quality were among the most popular European listed ETFs last year, adds Mr Boyadzhiev.

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By Kate Beioley,
25 August 2016

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