Getting started in multifactor ETF due diligence

Multifactor exchange-traded funds (ETFs) give investors diversified exposure to several investment factors, such as value and profitability, in a relatively low-cost and tax-efficient structure. However, with many options to choose from and often-complex strategies to sort through, comprehensive due diligence is a critical step when evaluating multifactor ETFs for investment.

Multifactor ETF due diligence

Why due diligence is critical with multifactor ETFs

There were 180 multifactor ETFs in the United States at the end of June 2019 with collective assets of $54.4 billion.¹ Multifactor ETFs are also continuing to see increased adoption, with 44% of financial advisors using them in 2019, up from 17% in 2016.² Some advisors may be using multifactor, a subset of the broader “smart beta” category, as a way to combine elements of active management decision-making with the systematic, rules-based investing of passive management.

Indeed, multifactor ETFs are more nuanced than traditional market-cap-weighted “pure passive” ETFs. For more plain-vanilla ETFs, due diligence can be fairly straightforward and usually involves an analysis of characteristics such as fees, liquidity, tracking error, performance, exposure the index gives you, and the sponsor of the ETF.

When it comes to multifactor ETF due diligence, investors need to consider all these typical ETF characteristics—and then dig much deeper. Some may argue that the due diligence process is more akin to evaluating traditional active managers. Multifactor ETFs do aim to deliver similar strategies employed by some active managers, but using a rules-based index approach. Therefore, a combination of both active-manager and index-ETF due diligence may be most prudent. 

From a structural perspective, investors need to consider the characteristics of the ETF as a vehicle—how it trades, its liquidity, size, and if it’s appropriate for the portfolio. Then, much like judging an actively managed fund, they need to consider their investment evaluation needs as well.

Multifactor due diligence combining ETF and active evaluation

Promoting good investor behavior

Some multifactor ETFs are relatively new and don’t have long track records, so understanding the underlying mechanics—before the purchase—is key to manage expectations and behavior. Multifactor investing requires a long-term view and discipline. Even though they diversify their factor exposure, there will be times when multifactor ETFs underperform the market. However, academic research shows that some factors such as size, value, and profitability have a performance premium over longer periods of time and multiple markets. Therefore, advisors and investors need to make sure they clearly understand the strategy so they stick with it.

Multifactor investing isn’t about performance chasing; rather, the goal is to identify a strategy that smartly and efficiently targets the desired factors, and in the right combination—and then using the fund correctly within an overall portfolio.

A due diligence checklist for equity multifactor ETFs

1. Goals and portfolio fit: What are you trying to accomplish with a multifactor approach (outperformance, risk reduction, diversification, etc.), and how does it fit in with the rest of the portfolio? How a multifactor ETF complements existing investments in the portfolio should also be considered.  

2. Identify the desired asset class and factors: This step involves deciding which area of the equity market to invest in, such as U.S. small caps or emerging markets. Then, the initial screen for relevant multifactor ETFs might be the fund’s selection universe. This step can help compare similar multifactor ETFs. Finally, which factors do you want exposure to? There are many factors, but the five main factors supported by academic research are:

  • Value: Stocks with lower relative prices have higher expected returns.
  • Size: Smaller stocks have higher expected returns.
  • Profitability (also called quality): Stocks of highly profitable companies have higher expected returns.
  • Low volatility: Stocks with lower historical volatility fluctuate less than the market.
  • Momentum: Stocks exhibiting positive momentum tend to continue to perform well in the short term.

3. Understand how the factors are measured: Investors need to look well beyond just a multifactor ETF’s name, just like they would with any fund. For example, there are many different ways to measure the value factor, including price-to-book, price-to-earnings, and price-to-sales ratio. There are also numerous ways to measure profitability, another key factor. The bottom line is that how a factor is measured can have a significant impact on how the fund performs and interacts with other factors bundled into the strategy, which takes us to the next step.

4. How do the factors work together? Multifactor ETFs have the benefit of factor diversification and remove the need to time individual factors, which is a difficult task. However, it’s important to understand how individual factors complement each other. One metric to look at is correlations between factors, or their tendency to move in tandem. This is relevant for diversification. Generally speaking, for example, value and momentum have negative historical correlations, so they tend to not move in lockstep. On the other hand, low volatility and profitability tend to be more positively correlated.

5. Index provider: Is the index creator an independent benchmark provider or is the ETF manager running the index in-house? What is the index provider’s pedigree and is the methodology backed by academic research? How long has the index been around? Answering these questions may help you find multifactor ETFs backed by well-constructed indexes, and avoid data mining and back-tested results that don’t perform as well in the real world.

6. Portfolio implementation and rules: How efficiently is the portfolio run and how skilled is the manager? Things to look for here may include tracking error, turnover, and tax efficiency (history of capital gains distributions). It’s also imperative to know if there are any rules or constraints on the portfolio, such as limits on turnover or concentration in individual sectors.

Putting it all together, due diligence with multifactor ETFs is vital as the number of offerings continues to grow. Making sure you have a firm grasp of the strategy before adding it to a portfolio will help you find—and stick with—the right multifactor ETF to achieve your goals. 

 

1 “Strategic beta ETF highlights: Q2 2019,” Charles Schwab Investment Management. 2 Ignites Research, August 2019.