Exploring Multi-Factor Models

This is Part 8 in a series about smart beta ETFs. See below for links to other posts in the series. So far we’ve looked at ETFs that target specific factors. In this installment, we look at funds that offer exposure to more than one.


Over the last few weeks I’ve looked at the five factors most commonly associated with smart beta ETFs: value, size, momentum, low volatility and quality. The specific funds I’ve mentioned so far are designed to zero in on one of those factors. But what if you wanted to target more than one? Should you just use several funds, or are their ETFs that use “multi-factor” strategies?

Let’s first consider the reason for building a portfolio with exposure to more than one factor: better diversification. As we’ve seen, each factor is virtually guaranteed to see periods of underperformance, even if they deliver higher returns over the long haul. This can lead to tracking error regret, which is the frustration investors feel when they lag the broad market. Unless you believe strongly in your smart beta strategy, you’ll be tempted to abandon it at the wrong time.

But although all of the factors will test your patience, it’s unlikely they’ll all be in the doghouse at the same time. In fact, according to MSCI, during the 40 years ending in 2014 momentum was negatively correlated with value and size, which means it tended to do better precisely when these other factors lagged. Quality and size also tended to move in opposite directions over this period. So by targeting more than one factor, you may be able to reduce the amount by which your strategy deviates from the broad market from year to year, while still capturing most of the long-term benefits.

Can you have it all?

Multi-factor strategies are not new in concept: Dimensional Fund Advisors, for example, has been using them for decades. Their funds originally gave extra weight to both value and small-cap stocks, following the Fama-French Three Factor Model described in the 1990s. Since then, DFA has expanded its model to include profitability, which is closely related to what we’ve called the quality factor. Unfortunately for DIY investors, however, Dimensional does not offer ETFs, and their mutual funds are not available through online brokerages.

In Canada, the largest suite of multi-factor ETFs was launched by iShares about a year ago. These include the iShares Edge MSCI Multifactor Canada (XFC) as well as similar ETFs covering the US and international stocks, with the latter two also available in currency-hedged versions.

These funds track the MSCI Diversified Multiple-Factor Indexes, which screen for value, size, momentum and quality. Stocks are assigned a score for each factor, and then a smaller number (ranging from 80 in the Canadian fund to more than 200 in the international version) are selected and weighted in the index. There are constraints to ensure the overall volatility and exposure to individual sectors don’t stray too far from the broad market. The indexes are rebalanced twice a year and limit their turnover to 40% annually, which is likely to reduce transaction costs and realized capital gains.

While these iShares ETFs are the only ones in Canada specifically designed to get exposure to several factors, other funds use strategies that sneak in through the back door. Take the PowerShares FTSE RAFI Canadian Small-Mid Fundamental (PZC), which targets both the value and size factors even if it doesn’t specifically market itself in that way. Another example is First Asset’s family of ETFs based on MSCI’s Risk-Weighted Indexes: these primarily target stocks with low volatility but also have a bias toward smaller stocks.

Other multi-factor ETFs

In the US, not surprisingly, the menu of multifactor ETFs is much larger. Ignoring the ones that focus on specific sectors, these include the following:

  • In the US, the iShares family of MSCI Multifactor ETFs includes not only funds that focus on US and international stocks, but also a version tracking emerging markets. There are even versions for US small caps and international small caps, which add a fifth factor (size) to the model.
  • State Street has its own suite of SPDR MSCI StrategicFactorsSM ETFs. Although these track MSCI indexes, the strategy is quite different from the one used by the iShares funds: they’re a composite of three individual indexes focused on value, quality and low volatility. There are versions for the various regions and individual countries.
  • The Goldman Sachs ActiveBeta U.S. Large Cap Equity (GSLC) tracks an index targeting value, momentum, quality and low volatility. Other ETFs in the family focus on Europe, Japan, international developed markets and emerging markets.
  • At least one ETF has been specifically designed to capitalize on the idea that some factors outperform when others lag: the PowerShares DWA Momentum & Low Volatility Rotation Portfolio (DWLV) is built from several low-vol and momentum ETFs, with the allocation to each one adjusted every month according to rules laid out in its index.

Other posts in this series:

Smart Beta ETFs: Your Complete Guide

A Brief History of Smart Beta

Understanding the Value Factor

Understanding the Size Factor

Understanding the Momentum Factor

Understanding the Low Volatility Factor

Understanding the Quality Factor



9 Responses to Exploring Multi-Factor Models

  1. adam October 11, 2016 at 7:14 am #

    I pine for the simplicity of the CCP from a few years ago

  2. Canadian Couch Potato October 11, 2016 at 8:04 am #

    @adam: There is only so much to say about traditional index investing, and after seven years and hundreds of blog posts I think I’ve said all of it more than a few times. It’s all archived on this site for new readers. I have had many requests from readers who are interested in smart beta ETFs and my goal here was to try and make sense of it for them.

  3. Kurt October 11, 2016 at 8:55 am #

    Thanks for putting this series together Dan. It’s been an interesting read and I’ve enjoyed following it.

  4. aslam October 11, 2016 at 10:14 am #

    Excellent information described in simple and condensed form for the DIY investors. With my limited readings of books and financial newspapers, I believe this this kind of information is difficult to find in one place. Great effort CCP!

  5. Raman October 11, 2016 at 12:28 pm #

    So CCP, the large question that remains unanswered is this: do you think the added complexity of such a “fancy all-dressed jacket potato” multi-factor solution (given by the XF* ETFs) is worth the added cost (in terms or MER, and turnover costs) over a more “standard potato” portfolio (given by, say the Vanguard Canada ETFs).

    Thanks for all the hard work!

  6. Canadian Couch Potato October 11, 2016 at 3:41 pm #

    @Raman: The series isn’t over yet. 🙂 Will definitely address that question in detail over the next week or so.

  7. Carl October 11, 2016 at 7:05 pm #

    @CCP: very interesting series, thank you for putting this together. Newbie question: in your post you mentioned “during the 40 years ending in 2014 momentum was negatively correlated with value and size, which means it tended to do better precisely when these other factors lagged. Quality and size also tended to move in opposite directions over this period”. do you know what the reason is for this negative correlation?. Thank you!

  8. Be'en October 14, 2016 at 5:22 pm #

    Have been enjoying reading this series. Thank you for putting it all together.

  9. Maxim October 17, 2016 at 8:21 am #

    Very interesting, thanks for the good work!

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