A Multi-Factor ETF Idea to Power a Portfolio

MarketsETF Trends

This article was originally published on ETFTrends.com.

Multi-factor exchange traded funds are expected to power smart beta growth in the coming years. One multi-factor that is already growing is the iShares FactorSelect MSCI USA ETF (NYSEArca: LRGF), which has nearly $1 billion in assets under management.

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LRGF, which turns three years old in late April, follows the MSCI USA Diversified Multiple-Factor Index. The ETF’s emphasized factors include momentum, quality and value.

Over the past few years, money managers and fund sponsors started to roll out rules-based, transparent index ETFs that combined some of the attributes that have historically provided active managers with outperformance, such as prominent investment factors like quality, momentum, value, low volatility and size.

“The fund's factor tilts are stronger than most of its peers', but its portfolio construction is opaque and complex,” said Morningstar in a recent note. “The fund's low fee and stringent risk management should contribute to its edge over the long run, but its short live track record limits its Morningstar Analyst Rating to Bronze.”

Through a multi-factored approach, these new smart-beta ETFs try to deliver enhanced returns and maximize diversification in an attempt to provide potentially improved risk-adjusted returns, compared to traditional market-capitalization-weighted indices.

LRGF holds nearly 150 stocks, none of which exceed weights of 2.54%. The ETF's largest sector allocation is 23.56% to technology. Industrial and healthcare stocks combine for about 26.6% of the fund's roster. Financial services and consumer discretionary stocks combine for 20.6%.

LRGF “fund uses an optimizer to construct its portfolio that weighs each stock's targeted factor characteristics against its risk contribution,” according to Morningstar. “This approach leads to inconsistent factor loadings because the optimizer shrinks its allocation to factors as their volatility increases. By targeting factors with low correlations to each other and constraining its stock and sector weightings, this strategy should diversify risk. But the optimization process is complex and opaque, which makes it difficult to assess how the portfolio will shake out.”

LRGF charges 0.20% per year, or $20 on a $10,000 investment, putting it on the lower end of expenses for U.S. large-cap smart beta strategies.

For more information on multi-factor strategies, visit our smart beta category.

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