Smart Beta ETFs: Weighing Single- and Multi-Factor Methodologies

Smart beta exchange traded funds have gained a lot traction in the investment community. The alternative index-based strategies were initially based on a single theme or factor, but now, investors can track multiple-factor investments in a single ETF to gain greater diversification benefits and smooth out their ride.

In the beginning, smart beta ETFs that track a customized portfolio beyond simple market capitalization weights allowed investors to target specific factors like value, growth or volatility to express an investment view based on the current market environment. However, this single-factor methodology presents some risks.

"One challenge presented by single factor investing is that single factors are cyclical, prone to periods of underperformance based on trends in the business cycle," Jennifer Bender, Director of Research at State Street Global Advisors, said in a note. "For instance, quality is typically associated with the late stages of the business cycle where profits are beginning to slow and corporate leverage is increasing."

In the current market environment, factors like low volatility, dividend yield and quality have outperformed. While these various factors help investors gain targeted exposure to specific objectives, investors may have more than one outcome in mind. This is where multi-factor smart beta strategies come into play.

Bender pointed out that smart beta ETFs may address an investor's targeted objectives and not just a single objective, diminish factor cyclicality, which may lead to periods of underperformance, and potentially create better buy and hold exposure for a balanced and diversified portfolio.

"With multi-factor, the low correlation between factors enables investors to take advantage of potential diversification benefits across factors, help improve consistency in performance and thus mitigate concerns of mistiming factors," Bender added.

Robert Bush, ETF Strategist at Deutsche Asset Management, likens multi-factor investments to Team USA at this year's Olympics where a strong group benefits from having a diverse skill set.

"The main benefit from sending 'the whole factor team' into a portfolio is that their diversified return streams can offset one another, combining to produce a basket of risk premia that perform under a wider variety of economic scenarios," Bush said in a note.

For buy-and-hold investors, multi-factor investments help combine uncorrelated investment styles to smooth out volatility. Since there are multiple uncorrelated factors at play, it helps guarantee that at least one factor will help support the portfolio during times of distress. Moreover, a multi-factor ETF removes the need for investors to babysit a portfolio and switch between factors in an attempt to time market moves.

"Instead, it enables them to rest assured that, whatever specific economic conditions generally prevail the approach will have factors that may shine, they will have a player on the pitch that can provide cover," Bush added.

As the ETF industry grows, investors are able to find a diverse set of multi-factor ETF strategies to choose from. For instance, State Street Global Advisors offers a suite of MSCI StrategicFactorsSM ETFs, including broad options like the SPDR MSCI USA StrategicFactorsSM ETF (NYSEArca: QUS), SPDR MSCI EAFE StrategicFactorsSM ETF (NYSEArca: QEFA), SPDR MSCI Emerging Markets StrategicFactorsSM ETF (NYSEArca: QEMM) and SPDR MSCI World StrategicFactorsSM ETF (NYSEArca: QWLD).

The SPDR strategic factor suite select components based on a combination of three market factors, including value, quality and low volatility.

"By combining quality and value, two return-based factors which also have a low correlation to each other, as well as different business cycle dependency (quality late cycle, value early cycle) with low volatility, a factor aimed at reducing the overall risk in a portfolio, an investor may be able to target multiple objectives (reduce risk, increase diversification and seek a higher return stream)," Bender added.

Additionally, Deutsche Asset Management offers a Comprehensive Factor ETF suite, including Deutsche X-trackers Russell 1000 Comprehensive Factor ETF (NYSEArca: DEUS), Deutsche X-trackers FTSE Developed ex US Comprehensive Factor ETF (NYSEArca: DEEF), Deutsche X-trackers Russell 2000 Comprehensive Factor ETF (NYSEArca: DESC) and Deutsche X-trackers FTSE Emerging Comprehensive Factor ETF (NYSEArca: DEMG).

The Duetsche X-trackers multi-factor suite selects components based on a broader five factors, including quality, value, momentum, low volatility and size.

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