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  1. Equity ETFs
  2. Smart Beta: Single Factor vs. Multi-Factor Approaches
Equity ETFs
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Smart Beta: Single Factor vs. Multi-Factor Approaches

Justin KuepperJul 30, 2015
2015-07-30

Smart Beta products have become increasingly popular over the past few years as a way to combine passive and active investing. As of December 2014, there were more than 700 smart beta exchange-traded products around the world, encompassing $529 billion in assets and about one-third of equity ETP flows, according to BlackRock’s estimates. These trends continue to grow as more and more investors seek investments with better risk-to-reward ratios.

Unlike traditional index funds, which are based on market capitalization, smart beta funds use alternative weighting methodologies in order to optimize certain characteristics of a portfolio.

Smart beta funds come in two flavors – single-factor and multi-factor – depending on the factors influencing the funds’ risk return profile. These factors might include value, momentum, size, quality, and volatility for equities or factors such as carry, curve, convexity, and momentum for fixed income investments. As the name suggests, single-factor funds focus on a single factor, while multi-factor funds consider many different factors when creating an index.

Single Factor Smart Beta

Single-factor index funds focus on a single factor, like value or momentum, when creating an index and investing. Using an index as a starting point, these funds apply a filter to categorically rank each security in the index and adjust the weights accordingly. A value fund might rank each component by price-earnings ratio and adjust weights accordingly, while a momentum fund may look at a technical indicator like the relative strength index.


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MTUM vs SPY Price Change

For example, the iShares MSCI USA Momentum Factor ETF tracks the performance of U.S. large and mid-cap stocks exhibiting relatively higher momentum characteristics. The largest holdings in the portfolio as of July 2015 include stocks like Amazon.com Inc. (AMZN) and Apple Inc. (AAPL), which were trading up 70% and 11% between January and July of 2015, compared to just 1.83% for the S&P 500 SPDR (SPY A) over the same time-frame (see Figure 1).

iShares operates a number of other single-factor smart beta funds, including:

  • iShares MSCI USA Value Factor ETF (VLUE B+) – Tracks large and mid-cap stocks with value characteristics and relatively lower valuations.
  • iShares MSCI USA Quality Factor ETF (QUAL A-) – Tracks large and mid-cap stocks identified through return on equity, earnings variability, and debt-to-equity.
  • iShares MSCI USA Size Factor ETF (SIZE A) – Tracks large and mid-cap stocks with relatively smaller average market capitalizations.

Multi-Factor Smart Beta ETFs

Multi-factor index funds focus on multiple different factors when organizing the weights of a given index. Using the same factors as a single-factor index fund, these funds combine them in innovative ways using proprietary algorithms in an attempt to beat the market. An algorithm may, for instance, determine that a parent index is being driven by value and then slightly overweigh value relative to other factors like momentum.

SPY vs SCIU Price Change

For example, Global X’s Scientific Beta US ETF (SCIU B) indexes combine value, size, low volatility, and momentum factors to assign weights to an index based on the Edhec-Risk Institute. While the fund has under-performed the S&P 500 SPDR (SPY A) (see Figure 2), it was only recently launched during mid-May of 2015 and there may not be enough data to determine its status.

iShares’ FactorSelect™ ETFs take a similar approach to using multiple factors targeting various subsets of global markets, including:

  • U.S. Large & Mid-Cap (LRGF B)
  • U.S. Small Cap (SMLF B+)
  • International Large & Mid-Cap (INTF B+)
  • International Small Cap (ISCF )
  • All Country (ACWF B-)

Comparing Performance

The primary question on the minds of investors is what performs best – single-factor, multi-factor or traditional index funds.

Multi-Factor vs Single Factor Chart

In Figure 3, we can see that the single-factor iShares MSCI USA Momentum Factor ETF (MTUM B+) was the best performing of the group. However, the single-factor iShares MSCI USA Value Factor ETF (VLUE B+) was the worst performing and the multi-factor iShares U.S. Large & Mid Cap FactorSelect™ (LRGF B) still beat the overall S&P 500 SPDR (SPY A). This variability persists when looking at various time-frames since factor ETFs were introduced.

There are also some other important considerations beyond returns:

SPYMTUMVLUELRGF
Expense Ratio0.09%0.15%0.15%0.35%
Turnover3.54%123.00%8.00%N/A*
Yield1.96%1.19%2.00%N/A*
*Not enough data to calculate

The reality of the situation is that single-factor funds will likely perform best, but investors must select the right factor at the right time. By contrast, multi-factor funds may not deliver the best returns possible, but they seem to consistently beat their benchmark indexes over time by optimizing the weighting of the portfolio based on changing factors. Passive investors may want to consider the latter as a hands-off way to improve their portfolio performance.

At the same time, investors should remember that single- and multi-factor smart beta ETFs have higher expense ratios and greater turnover that could eat into returns. Many of these ETFs still seem to be outperforming their benchmarks, but changing market dynamics could alter those trends and create some concerns for passive investors.

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