What’s Inside Your Multifactor ETF?

Over the past few years, investors and advisors have been presented with a question: Can smart beta be made smarter?

Smart beta, as you no doubt know by now, is an investment approach — usually wrapped in an exchange-traded fund — that’s a sort of middle ground between active and passive management. A smart beta fund employs a mechanistic index methodology designed to play up an investment factor, or attribute, such as low volatility or high dividends. Some funds’ index strategies synthesize a couple of these attributes. Low volatility stocks together with high dividend payers, for example, is an equity strategy exploited by both the PowerShares S&P 500 High Dividend Low Volatility Portfolio (NYSE Arca: SPHD) and the Legg Mason Low Volatility High Dividend ETF (Nasdaq: LVHD).

The first true multifactor ETF was launched in 2011. “Factor,” in this context means a tilt in the direction of high book-to-market value and small capitalization consistent with the Fama-French model.  

A multifactor ETF differs from style-tilted portfolios, such as the iShares S&P Small-Cap 600 Value ETF (NYSE Arca: IJS), which were floated a decade before by dint of scope and dynamism (see “Growth Or Value? Which Way To Lean?”).

IJS tracks a committee-determined index of small-cap stocks exhibiting low price-to-book, price-to-sales and price-to earnings ratios; IJS’ investable universe is limited to small-cap stocks. A multifactor fund, such as the FlexShares Morningstar U.S. Factor Tilt Index ETF (NYSE Arca: TILT), quantitatively culls the entire market — across all capitalization tiers — to find those stocks that, when combined, best express the small-cap and value factors. You won’t find large-cap stocks in IJS, but you will find them in the TILT portfolio.

Being the first to market, TILT is the granddaddy of domestic multifactor ETFs. TILT manages 32 percent of the $3.3 billion now invested in domestic multifactor ETFs.