Single vs Multi-Factor ETFs
The irresistible charm of factor investing (single or multi-factor ETFs) lies in their ability to offer potential for out performance, which has led to their explosive growth in recent years. Traditional index funds only use market capitalisation as a factor. Smart-Beta Funds offer a variety of alternatives by offering different weights and factors that can potentially deliver better performance. Such factor-investing allows the flexibility to create a strategy based on one or more factors (drivers of return) that one believes can outperform the market. This choice of factor(s) allows for combination of weights for each security that would otherwise be based purely on the market-cap.
Some of the common factors chosen for single or multifactor ETFs are: Size, Volatility, Momentum, Value, Style and Quality. Many funds use their proprietary algorithms to create weights and optimize them over time. There can be custom factors as well such as dividend yields, liquidity, etc for equities and curve, convexity, etc for fixed income.
So, when to choose Single-Factor or Multi-Factor for your ETFs?
Single-factor ETFs are built on the idea of finding the factor that will drive the risk-adjusted returns during the investment horizon. Each factor suffers from cyclicality in performance. The cyclicality may not coincide with the investment horizon, hence diversification of risk across a set of factors that balance out each other’s cyclicality may offer better performance and less risk.
Multi-factor investing can be implemented in either a top-down or bottom up way.
Multi-factor ETFs have grown rapidly. There are over 300 multi-factor funds with an estimated $70-80 billion in 2018 from just $3.8 billion assets in 2009. However, ETFs can be as varied as zebra lines. Many ETFs may not even be promoted as multifactor ETFs. For example, FlexShares Morningstar Global Upstream Natural Resources Index Fund (GUNR) does not emphasise that it is a multifactor ETF. However, they do mention in their literature that GUNR’s index implements diversification through liquidity and size as factors, allowing them to combat “factor-specific risks”.
Performance of Multi-factor ETFs
The performance of multifactor ETFs has been a mixed bag when compared to single-factor ETFs. However, it is important to understand the purpose of choosing a multifactor ETF over either a single-factor ETF or a pure passive index tracker. Single-factor funds usually perform better over longer period of time as the chosen factor is the one driving the performance.
Multi-factor ETFs offer a well-balanced risk return profile for investors by spreading the risks across the chosen factors. Only a thoroughly back-tested multi-factor strategy can efficiently distribute the risks by understanding the interplay among various factors. Hence, it is vital to recognize the purpose of investment when choosing factors for such investment strategies.
Costs of Single vs Multi-factor ETFs
Factor ETFs are usually on the high end of ETF cost structures. While pure passive ETFs start as low as 5 basis points, single-factor ETFs can typically charge around 60 basis point in annual fees. Multi-factor ETFs are roughly 10-15 basis points costlier than single-factor ETFs. This extra cost of multi-factor ETFs accounts for the expertise of the fund manager to find the right balance among the factors. For an investor with long investment horizon, this extra cost is usually justified when the multi-factor strategies prove robust over multiple market cycles. However, compared to 100-150 basis points of management fee charged by active funds, multi factor ETFs are still much more cost effective.
How can Parity One help you build single or multi-factor ETFs
Pairty One is designed as an end-to-end platform to build and manage factor-based investment strategies easily and efficiently. We understand that thorough back-testing is the key to finding the secret sauce and prove to your investors why your strategy is robust. Parity One can help you achieve that with ease and speed. Parity One’s sophisticated back-testing framework enables simulating the most advanced factor-based investment strategies and converts them into fully managed bespoke indices that can be launched as ETFs.
Parity One’s multi-factor design studio helps you understand the interaction between different factors and suggest the right mix of factors for a chosen investment universe. Parity One can also adjust the factors dynamically based on the desired set of outcomes as defined in the investment strategy.
If you are thinking of launching a new ETF or to optimise an existing one, give us a call to find how Parity One can help you.