Multifactor investing, which combines a focus on factors such as company size and volatility, is all the rage in the exchange-traded fund (ETF) world. Multifactor strategic-beta ETFs enjoyed a net inflow of $7.3 billion for the 12 months through June 30, boosting their total assets to $46.4 billion.
Factor-based investing targets securities with characteristics that have historically been associated with higher returns and/or lower risk. Those characteristics can traditionally range from low valuations to high profitability to the size of a company, though the evolution of the market in recent years has spawned a multitude of factors.
Combining more than one factor tilt in a single index is intended to provide an investor easy diversification of the strategies; however, this approach has been criticized as being convoluted and minimizing the benefits that come from a single focus. We turned to Shundrawn Thomas, head of Northern Trust Asset Management’s FlexShares ETF division, to explain what’s happening in the multifactor arena. Thomas was recently named president of Northern Trust Asset Management, effective October 1.
FlexShares says it invented the first multifactor fund, FlexShares Morningstar US Market Factors Tilt Index Fund, in 2011. That fund, which uses both small-cap and low-valuation factors, now has over $1 billion in assets, with returns that bested the S&P 500 last year by almost five percentage points and has an expense ratio of 25 basis points, below the category average, according to Morningstar. FlexShares now manages 13 multifactor funds in total.
Thomas sees multifactor funds as a way to enhance risk-adjusted returns. The funds can make up a large percentage of investors’ portfolios depending on what their objectives are, he says. Advisors can help their clients by sifting through the plethora of multifactor funds and figuring out which ones best suit the clients’ investment goals.
WealthManagement.com: What’s the appeal of multifactor funds for investors?
Shundrawn Thomas: When you look at size, value, momentum, quality, you know over time you are providing investors with a risk premium. Then you need to have an investment approach that captures the risk premium and will enhance investment performance, capturing particular outcomes.
There are ways in which factors can complement each other, if you can combine them the right way. In some environments, one factor may underperform, and the loss may be offset by another factor.
WM: What are the most important factors?
ST: That boils down to which factors are persistent, resulting in a risk premium over a long period of time. A lot of research shows that these factors are size, value, momentum, quality and volatility. When we say size, we’re talking about small-cap [stocks]. Volatility is low volatility.
WM: How should investors choose among multifactor funds?
ST: Every investment fund should have a clearly articulated objective, and investors should be clear what they are trying to achieve. Is that fund in line with the goal that the investor has?
Sometimes people myopically say they just want the best return. But it matters how you get it. If you’re taking outsized risk, you might have a lot of downside exposure in negative market environments. You can see whether the return is smooth or volatile. The question is, over time, does the fund deliver against its objective?
Test funds’ methodology. It’s not like making dessert, where the more toppings, the better. They should clearly articulate why they’ve combined factors and what outcomes they’re trying to achieve. Obviously, risk-adjusted return is important. Make sure you compare funds to similarly situated products.
WM: Is it important to have more than one multifactor fund for diversification?
ST: Generally, diversification is good. If you have a clear objective and a good fund meeting that objective, you don’t necessarily need multiple funds. The question is what combination of funds do you need for your objective. You don’t want a proliferation. You want thoughtful contributions that add value to your portfolio.
WM: Should multifactor funds make up a large percentage of your portfolio?
ST: They can. It’s a matter of tying them to your objectives. You want your investments to have exposure to these risk factors in a purposeful way. To the extent you’re doing that, multifactor funds can make up a meaningful part of your portfolio. You’ll have these exposures on some level anyway.
WM: What are the most difficult elements of multifactor investing for the fund providers, financial advisors and advisors’ customers?
ST: For providers, the challenges are the opportunities. When developing a strategy, you have the responsibility to assure investors that the strategy achieves its intended end. You have to do empirical research and also make sure you have an approach that delivers those outcomes.
For advisors, one question is, how do you go about choosing among a lot of alternatives? You need a process in place to assess the sea of options. One way to solve that is, when you find [fund managers] who are effective, build a partnership with them. It’s important to have depth of relationships, not necessarily breadth.
The other question for advisors is, how do you make all of this make sense to the client? We’re interested in the science and terminology of investing, but clients are interested in the outcome. You have to translate the complex into simple terms.
As for the clients, they don’t have to understand all the science. The question is, do I have a trusted advisor who has the requisite acumen? It’s the choice of the advisor.
WM: Do you worry that the rush of money into multifactor funds could lead to increased volatility?
ST: No, we’re very much long-term investors. If you work with clients who also are that way, you can deliver on solutions and don’t have to worry about short-term disruptions or noise in capital markets.
One of the challenges for providers is not so much the rush of flows, but the misrepresentation of it. Can your message come through, as opposed to how something is marketed. You have to avoid being tainted by bad players. That’s true in every industry.
WM: What do financial advisors do well, and where can they improve?
ST: The best advisors start with a keen focus on the objectives of their clients and are able to translate those into clear investment goals. To the extent advisors do that well and serve their clients, that makes it easier for a [fund] provider to partner with them. You also should have a clarity of philosophy and approach, so I can understand how to come alongside you in terms of products and advice.
As for what advisors can do better, risk management is so important. More advisors could use tools and approaches that infuse more deliberate risk management. Tools for risk management are important, and multifactor investment is one strategy. It enhances your ability to manage a portfolio well. It helps you manage risk factors. As advisors deploy more of that [risk-management] tool kit, we see almost by definition more utilization of these strategies.