How to mix and match ETFs with a ‘style’ bias

Monika Dutt explains how new ETFs weighted to combinations of factors such as value and size are delivering strong results.

For many investors, market-capitalisation weighted funds are a good place to start. By tracking benchmarks such as the FTSE All Share or the S&P 500 index, these funds offer exposure to the broad market at a low cost. However, those seeking to improve the return or reduce the risk profile of their portfolios may consider funds that tilt towards one or more factors relative to the broad market. 

Factors such as size (smaller companies outperform large caps), value (cheap stocks outpace expensive stocks) and quality (profitable firms beat unprofitable ones) have been extensively studied and tested both in academia and in practice. It has been shown that such factors offer better risk-adjusted returns relative to the broader market over the long term. 

But while single factors tend to outperform the market over the long haul, each factor can go through long spells of underperformance. As a consequence, investors holding single-factor funds run the risk of abandoning these strategies at precisely the wrong time. 

Index construction counts 

There are ways to mitigate those risks. Funds that combine factors with low correlations to one another, such as small size and quality, can yield a more stable risk and reward profile than any single-factor fund in isolation. A smoother ride may help investors stay the course when a factor falls out of favour.

That said, multi-factor funds are not all created equal. Take the UBS MSCI USA Select Factor Mix and the iShares Edge MSCI USA Multifactor ETFs, for example. The two ETFs, which are both rated Bronze by Morningstar analysts, choose stocks from the same universe, namely the MSCI USA Index. But their portfolios are distinct. This is mainly because they use different factors and are constructed using a different methodology. As always, index construction matters. 

When it comes to combining factors, there are two major approaches. The first approach mixes single factor indices together, while the second approach selects stocks that have the highest exposure to all the target factors simultaneously. There are, of course, merits to both of these approaches – for example, the former strategy follows the broader market more closely, while the latter offers more aggressive factor tilts.

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The UBS ETF implements the first approach. This fund equally weights six single-factor MSCI USA indices, including value, size, momentum, buyback/shareholder yield, quality and low volatility. The fund’s main advantages are its simplicity and transparency. By combining single-factor indices, it’s easy to understand the contribution each factor makes to performance. In addition, the fund’s performance won’t stray too far away from the MSCI USA index performance. 

It’s tempting to assume that by equally weighting single-factor indices, investors gain equal exposure to all factors. Not so. Complementary factors may wash each other out. As such, the main drawback of the mixing approach is that it may result in relatively muted factor exposures. 

Constraints on the benefits

Meanwhile, the iShares Edge MSCI USA Multifactor ETF seeks to maximise its exposure to stocks with attractive value, momentum, small size and quality characteristics. As a result, this ETF is likely to achieve deeper factor tilts than the UBS fund. 

The main concern we have with the iShares ETF is its complexity. The fund’s underlying index uses an optimiser to select stocks with the desired factor characteristics under a set of constraints, including single-stock weight, sector exposure and turnover restrictions. These ensure that the portfolio remains diversified, is cost-efficient, and doesn’t deviate from the MSCI USA index by too much. In other words, the ishares portfolio is constructed in one go, making it difficult to explain why a certain stock was chosen over another one. 

Against this, while the UBS ETF is simple to understand, it doesn’t consider the portfolio’s overall exposure to factors. Individual factors are combined without addressing how these factors work together. By comparison, the iShares ETF offers a more holistic approach to factor investing. It achieves higher factor exposures, but at the cost of lower transparency. 

In addition to these considerations, it is important to mention that these funds have not established meaningful performance histories yet. For these reasons, we have awarded both of the ETFs Morningstar Analyst Ratings of Bronze, reflecting our positive but conservative conviction in their long-term ability to outperform their US large-cap peers. 

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