Multifactor ETFs: focus on portfolio construction, not factor timing

Factor investing is based on academic research showing that stocks with specific characteristics, known as factors, have historically outperformed the market over longer time periods. Size (small caps) and value are perhaps the best-known factors, but there are others such as profitability (quality) and momentum.

The truth is that individual factors like size and value can fall out of favor, sometimes for years, despite their historical long-term outperformance. That’s why strategies that combine several factors, such as multifactor ETFs, may help investors stay on track.

Recently, small-cap value stocks have underperformed while large-cap growth stocks have been hot—particularly some of the market’s biggest tech companies. We believe the dominance of large-cap tech stocks can create diversification and concentration issues for core equity portfolios, which we discuss later.

The performance disparity between U.S. small-cap value and large-cap growth, which has been particularly acute over the past year, has some contrarians asking if now presents an opportunity to buy or add to small-cap value stocks.

However, we think this market-timing approach is the wrong way to think about factor investing and multifactor ETFs for several reasons, including:

• We don’t believe it’s possible to predict which factors will perform best. It’s difficult to time individual factors such as momentum, quality, value, and size.
• History shows that market trends, such as the outperformance of large-cap tech stocks, can continue longer than many expect—and then reverse very quickly.

Therefore, the admittedly unexciting answer is that we believe the best way to capture factor premiums is simply to remain invested, rather than trying to time them. That’s why we recently wrote that discipline is key for investors in multifactor ETFs, particularly in volatile markets or when individual factors are underperforming.

Remember, individual factors like value can recoup years’ worth of underperformance in a very short period during major market shifts, as after the dot-com bust. This is more evidence arguing for simply maintaining exposure to factors as a practical, realistic way to capture the long-term performance premiums.

Aside from efficient tools to capture long-term factor premiums, we believe multifactor ETFs may also help solve common portfolio-construction challenges in today’s environment.

For example, many investors use the market-capitalization-weighted S&P 500 Index for core exposure to U.S. stocks. However, the recent dominance of large-cap tech stocks means the index is getting more top-heavy, which may create hidden concentration risks.

The S&P 500 Index is also seeing its concentration in the tech sector rising to the highest levels since the dot-com bubble.

Multifactor ETFs could be one way to diversify or complement core U.S equity portfolios that may be concentrated in large-cap tech and growth stocks.

Putting it all together, when it comes to factor investing, we favor a time-in-the-market approach, rather than a market-timing approach. We think combining several factors in a multifactor ETF can help keep a long-term perspective, since other factors such as profitability may outperform when other factors such as size and value are lagging. Finally, multifactor ETFs may also be used as portfolio-construction tools to address concentration risks due to the recent outperformance of large-cap tech stocks.