While ETFs are most popularly known as plain broad-based index investments, certain ETF products try to mimic active management by going beyond market-cap weighting. These include smart-beta strategies
, which allocate assets based on factors aside from market capitalization like momentum and value.
However, smart-beta strategies that focus on a single factor can underperform
, which is why multi-factor ETFs are become popular. While the basic premise behind multifactor ETFs is the same, there are different ways to construct them.
“Most multi-factor indices or ETFs tend to follow two primary methodologies: factor-mixing or factor-tilting,” said Joe Smith, senior market strategist at US-based CLS Investments, in an article on ETFTrends.com.
“Factor-mixing involves taking a number of single-factor indices and weighting them (and their underlying holdings) to determine the final list of securities and their allocations represented in the portfolio,” he said. “Factor-tilting takes a more bottoms-up approach by tilting towards various stocks based on their exposure to multiple factors simultaneously.”
In the factor-mixing approach, companies with larger market caps tend to get a greater weight even if they don’t score as high as other stocks in the parent index for a certain factor. Meanwhile, the factor-tilting approach tends to bias toward securities that have high scores across all factors considered, though it still depends on each stock’s market cap.
However, “[b]oth methods generally yield similar results,” Smith said. “Ultimately, stocks more likely to score high on multiple factor definitions tend to have a greater emphasis in the final index.”
But while multi-factor ETFs are argued to place investors closer to investment exposures that can compete directly against active managers, the allocations active managers arrive at are different. According to Smith, active managers tend to select pools of stocks based on their investment philosophies. For example, value-oriented managers may totally disregard stocks that score low on value, which can create a portfolio that lacks exposure to other factors; multi-factor strategies, on the other hand, will tend to have reasonable exposures across all factors targeted.
And even though multifactor strategies still tend to rely on market capitalization, Smith said that de-linking multi-factor indexes from each company’s individual market cap “can enable the index to capture additional excess return over time on a risk-adjusted basis.”
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