With a catchy title like Building a multi-factor portfolio with iShares FactorSelect MSCI World ETF, this post should go viral like anthrax any second. Any second now…
While we wait, if you fancy superior portfolio diversification and the potential to grind the market performance under your heels, it’s time to look at the new multi-factor ETFs out there.
The pitch? Ready access to the investing rocket fuel known as the return premiums (or risk factors) in one family-sized power pack.
The risk factors are purified concentrations of equities that have historically beaten the market.
The value factor, for example, focuses on companies that appear cheap in comparison to their fundamental value.
Meanwhile the momentum factor takes advantage of the tendency of recent winners to keep on rising and losers to keep on sinking.
If you’d tilted your portfolio towards these kinds of companies you’d have done very nicely in the past. And who knows? Maybe in the future too…
Negative correlations, positive connotations
Just as a global equity tracker diversifies you across continents and countries, a multi-factor ETF diversifies you across the different sources of equity return as embodied in the risk factors.
In the case of the iShares FactorSelect MSCI World ETF (IFSW), you gain exposure to value, momentum, size and quality, as well as the global developed market.
And that’s a particularly fruity combination of factors. They are complementary, like a band of heroes where one’s the muscle, one’s the brains, one’s the healer, and one doesn’t seem to do much but sure is pretty.
History and academic research tells us:
- Value and momentum have generally been negatively correlated.
- The correlation of momentum and quality has been low.
- The correlation of quality and value has been low.
- Size has had no correlation with momentum and a negative correlation with quality.
Negative correlations1 are the holy grail of portfolio diversification because as the fortune of one investment wanes the other often waxes.
It’s a bit like placing your bets on Bond and Blofeld. When Bond is on the rack with a laser cutter pointing at his testicles, Blofeld is usually laughing his pink crash helmet off. When Blofeld’s volcano base is on fire, Bond is usually off nobbing some beautiful Russian agent.
The idea is that you’re backing whoever’s winning at the time, which means your overall portfolio returns tend to be more consistent and less subject to catastrophic downfalls.
Okay, that’s a colourful oversimplification that will probably blow The Investor’s pedantry fuse, so let’s have a more instructive, real-world example.
We can compare the one-year returns of the four factors in iShares’ single-factor ETFs, along with the plain ol’ world ETF.
We only have returns for one year because iShares’ factor funds are so new.
As you can see, both the size and value factors went into negative territory last year scoring -1.6% and -4.3% respectively.
In fact, both factors underperformed the market which delivered -1%.
So far, so miserable.
But what’s this? Momentum and quality rode to the rescue with respective returns of 2.6% and 2.1%! Both factors beat the market and put in a positive shift as size and value hit the skids.
If you’d put all four factors into a single portfolio then you’d be hoping that over time the positive returns outweigh the negative and romp past the market return, too.
And (fortunately for my example) that’s roughly what happened last year.
A portfolio quartered between the factors would have returned -0.003 (let’s call it nothing shall we?) while the regular world portfolio lost 1%.
Naturally, correlations aren’t guaranteed or always reliable.
But they are the essence of diversification, whereby you maintain good returns over time and aren’t caught out when a particular asset or factor falls from grace for years on end.
Too many eggs, not enough baskets
One of the reasons why factor investing is hard is because a single factor can underperform for a decade or more.
Investors lose faith, sell, collect their poor returns, and wander off to graze on whatever’s looking better at the time.
But well-structured multi-factor funds could be the antidote.
As Jared Kizer of the respected BAM wealth management group has shown, while the market delivers positive returns in 60% of all months, at least one factor will deliver a positive performance in 96% of all months (Kizer’s study combined the market, size, value and momentum factors).
So while a multi-factor fund may not trounce the market – which a more concentrated bet such as a value fund can occasionally do – it’s also less likely to get absolutely spanked and make you do something dumb when the negative numbers seem to blur and then coalesce to spell the word IDIOT.
Of course, you could invest in individual factor ETFs for yourself.
But aside from being easier to use, a multi-factor ETF also has the potential to be cheaper than separates because you don’t have so many funds to trade.
It will also rebalance internally for you, again saving on trading costs and also saving you the mental anguish of selling winners and buying losers.
A multi-factor fund further filters out some of the contradictions of holding negatively correlated factors like value and momentum.
In a separate-fund situation, you can find that a share is sold (perhaps because it has lost momentum) only to be bought by the other fund (because it now qualifies as value).
A fund like IFSW, however, is looking for smaller sized, quality firms with momentum that are cheap. So its turnover should be less than a fund that’s only looking to buy and sell along a single dimension.
IFSW – quick summary
So is IFSW the multi-factor fund we’re looking for?
Well, it’s the only choice we’ve got if you want a combined package of value, momentum, quality and size.
Its closest rival is the Amundi ETF Global Equity Multi Smart Allocation Scientific Beta (SMRU). While the name is as cuddly as a killer robot, the ETF itself tracks value, momentum, low volatility and size. (Like a cuddly killer robot.)
I’d rather have quality as part of my factor set but this is still a decent combo, so I’ll look into SMRU separately.
In the meantime, IFSW has a reasonable OCF of 0.5% and it tracks the MSCI World Diversified Multi-Factor Index.
MSCI have published a paper that explains the index in-depth and provides more transparency than most smart beta products. A good sign.
IFSW only launched in September 2015 though so it’s impossible to say yet whether its results will add anything in comparison to a vanilla world tracker.
In all honesty, we’ll need a minimum of three to five years of data before we’re judging on anything more than noise.
What I really want to know is whether IFSW is worth holding as a portfolio diversifier.
Unfortunately, it’s too new to be subjected to a Morningstar X-Ray that can identify overlap between fund holdings.
But a manual comparison of IFSW’s assets against its vanilla cousin, SWDA (iShares’ core world tracker), suggests that the two are sufficiently different.
IFSW is unlikely to go down any bizarre investment rabbit holes either.
In the past, Monevator readers have looked at global smart beta funds, only to retreat in horror when they turn out to be concentrated 70% in Japan Consumer Staples or something similarly exotic.
But MSCI has put limits on how far the multi-factor index can differ from its vanilla world parent index.
That shackles IFSW’s ability to blow the world index away in terms of returns. But it also curtails the risk of it deviating dramatically down from the market and making it feel like you own a pair of concrete boots instead of a fund.
Hiccup
Before taking the plunge, you should also check the index methodology’s explanation of its factors.
I, for one, am not convinced by MSCI’s definition of quality, as I have previously explained.
The value and momentum definitions also stray significantly from the classic formulas used by academics that have lain the foundations for factor-based investing.
That’s not necessarily a bad thing. It’s widely recognised that there are many ways to skin a factor cat.
Moreover, different factor metrics will outperform at different times, which leads many commentators to believe that multiple metrics are the way to go because they provide another form of diversification.
But it’s impossible to tell if IFSW’s multiple metrics will excel in the future, so I’d personally be more comfortable if it tacked closer to the classic formulas that have proved historically robust.
In the absence of that – or any real multi-factor competition – IFSW gets a cautious nod as a welcome portfolio diversifier.
Take it steady,
The Accumulator
- If you can’t get negative correlations then uncorrelated or low correlated assets are next best. [↩]
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The plain Vanguard etf msci world tracker has a quoted annual charge of half of this
That 0.25% annual charge saving may sound small but its the equivalent of slightly over 10% of the annual dividend you will see from the etf
Bird in the hand beats birds in a notional diversified coppice in my opnion
Thx for commenting on this ETF. AS you said, it is a little young to be judged on his performance and value in a diversified portfolio. Maybe as a little sidekick for now?
Experience has taught me to be wary of these strategies that work in theory, but are not in the long-term investable. I’ve wanted to believe in the power of RAFI and smart beta, but the wide spreads and higher costs put me at an immediate disadvantage. On several occasions I have bought a fund and then shortly afterwards received notification that it is closing due to never achieving critical mass of AUM. This also triggers a random CGT event. The logic of avoiding market weighting is very appealing, but so is the transparency and (now) extremely attractive pricing of standard trackers.
A very interesting article, and as usual entertainingly written.
My immediate and unconsidered response is that passive investors can be persuaded to buy into a well diversified index etc and then sit back and wait for long term reasonable performance. …and then along comes another idea to divert us. Maybe better or worse, time will tell. Just cos it is logical does not always help.
To divert or not to divert…that is the question. Not yet!
These funds are starting to proliferate in the US. I’ve heard good things about GSLC.
I’ve spent a good amount of time recently trying to research how to construct or allocate assets as a passive factor based portfolio. Conventionally, this means a world equity tracker for size, plus tilts for factors. Usually authors advocate sticking to one or two, and these are typically Value and Small. Having said that, UK passive vehicles are difficult to come by that track these well and they are flawed proxies. Monevator’s low cost tracker page acknowledges this.
Enter a new breed of factor based ETFs – Quality, Momentum, Volatility, Liquidity. Vanguard’s recent ETFs are a good example. They are often “Active” in name, but active and passive lie on a gradient. Personally, I’m happy with a low fee vehicle that has an open and published algorithm for fund selection that is committed to small changes and has a scientific and historical basis, even if they are labelled “active”. Yeah, right.
The literature says that you need to select these based on your own risk profile. For instance, historically Momentum gives higher returns over long time periods but is dreadful in downturns. There is isn’t anything out there that says “If you’re the type of person that holds 80% VWRL, 10% Small, and 10% Value, then with the advent of factor trackers you are better off with X”.
I’ve watched Ferri and Swedroe spar on the topic and figure if they can’t agree then I’m out. I don’t want a free lunch. I want the best value lunch.
I’m sort of at the place I’m ready to replace my 10% of equities I have in VHYL with a Quality Factor ETF but that’s mostly because VHYL is the wrong shape. I might consider a Momentum tracker, maybe at the expense of Small, but I think I’ll give it a year or two to shake out before making any change. Maybe fees will drop as AUM increase. I don’t subscribe to a vehicle that manages a bunch of factors, its too much of a black box for me.
Interesting topic.
Hi Accumulator,
Thank you for the interesting article.I’ve just about got my head around plain vanilla low cost tracker funds and LifeStrategy products. So I think for the moment, and until I move my investing knowledge to the next level, I’ll stick with what I understand.
phew , just when i thought id got my portfolio sorted!
It was just the past. If it is so easy to gain without pain everybody will buy smart beta and the premium will vanish.
There is no magic just naive people. As always.
http://thereformedbroker.com/2016/02/05/five-things-smart-beta-cant-do-for-you-2/
The risk factor premiums might vanish, Gregory. Definitely a possibility. And if they don’t then easier access is likely to reduce them.
But they have survived discovery and have been found to exist across a wide range of geographies, asset classes and time. And they may continue to do so because they do bring pain and risk. Risk factors can underperform for many years creating the conditions whereby they survive – i.e. they fall out of favour, they become relatively cheap and those that stuck by ’em capitalise.
Incidentally, I wouldn’t blame anyone for leaving the risk factors alone. They are an extra complication and are not guaranteed to work. The products themselves may only deliver a spoonful of the supposed rewards on offer.
rg – from what I’ve seen Swedroe and Ferri essentially agree on the merits of factor investing though they may differ on some of the detail. They have access to a better choice of funds though in the US.
@ The Accumulator – “One of the reasons why factor investing is hard is because a single factor can underperform for a decade or more.
Investors lose faith, sell, collect their poor returns, and wander off to graze on whatever’s looking better at the time.” This is what I believe in: no pain no gain. And this is why Buffett’s s favorite holding period is forever.
Had to stifle a giggle at your James Bond reference. Who would have thought multi-factor investment could be such fun?
I just hope that nobody takes the diversification pitch too seriously. I worry that a naive investor would read the description of the lack of correlation between factors and come to the mistaken conclusion that this product will protect them against market falls only to discover that, instead of buying a parachute, they have actually bought a yoga mat.
Good summary of another interesting product. Although, wasn’t it Auric Goldfinger rather than Blofeld who was aiming that laser at Bond’s knackers? Still, it sums up your point nicely.
@acc yes it’s mostly semantic sparring as seen at https://www.bogleheads.org/forum/viewtopic.php?t=125060 and https://www.bogleheads.org/forum/viewtopic.php?t=163808
Ferri hates the term smart beta and seems to think the factor returns come at a risk that must be paid, it’s not superior to conventional allocation, it’s additional rewarded risk.
Swedroe is resigned to the term and seems to believe a factor tilted portfolio is superior to conventional asset class production.
Ho hum.
As a relative newcomer to passive investing I struggle with how to approach this kind of article – I feel a conflict between this kind of product and my passive approach – I am trying to remove timing/”asset allocation which attempts to out perform” from my investing approach. I wonder whether my globally diversified portfolio is sufficient when I read this kind of article. I have to assume these products are aimed at the passive investor who has active tendencies.
I suppose my question for the accumulator is whether these products are appropriate for the average or “true” passive investor. Apologies if I have missed something in the article which addresses this point.
@J.B. — I think The Accumulator effectively answered your question a few replies above:
We’ve written loads about the pros and cons of these sorts of vehicles in the past. Have a hunt here:
http://monevator.com/tags/return-premium
In short, neither he nor I for that matter think anyone *needs* to invest using any kind of factor-fund in order to meet their long-term investing plans. Far from it!
However that’s different from saying the products have no appeal for some people who are prepared to take the extra risk for potentially higher rewards.
Hope this helps!
Fund managers ready for ‘smart beta’ wars:http://www.ft.com/intl/cms/s/0/f1d345ae-c913-11e5-be0b-b7ece4e953a0.html#axzz3zmZn4jMf
I would suggest that being aware of developments in products, investment strategies, market changes, etc is important. Even for passive investing types.
That is not the same as saying that any action necessarily follows.
@oldie
Good point. I do get slightly annoyed when people’s only response to something like this is just to repeat “smart beta will vanish” like a mantra, as if it was the greatest insight in the world. It might do – or it might not. You might have other reasons for avoiding smart beta (general scepticism, costs, complication, timeframes etc.). And none of these should prevent you from learning.
I’m keen to give a multi factor ETF a go, but I really can’t get over the 0.5% OCF of the iShares offering.. Surely Vanguard will offer a (cheaper) multi factor ETF soon, seeing as they’ve now got individual smart beta products..
On a slight tangent, I saw not one, but two black swans swimming down the river yesterday. I’m not quite sure what to make of it.
I mean to choose only one factor (I prefer value). Through thick and thin. .
@ Dave – which of your funds have closed down? Would be interesting to see if there was a pattern.
@ Tim G – nice analogy. I certainly don’t mean to suggest that diversifying among sources of equity return is equivalent to a bond / equity split. You won’t get protection during a stock market rout from long-only equity funds. But over the long-term you can expect to benefit from tapping into multiple sources of return and rebalancing between them.
@ Rhino – chortle. Glad it wasn’t the Four Black Swans of the Apocalypse.
I’m a victim of RAFI. I know that the outperformance could take some years to arrive and am prepared to wait. Unfortunately, it seems that you can’t build any momentum behind a fund until you actually do outperform. Thus assets dwindle and the fund shuts. There was a Japanese one that disappeared a few years ago, and the Rest of Asia one is about to go. Looking at the latest AUM figures it wouldn’t surprise me if another few bite the dust. Luckily the costs of more conventional trackers have fallen enough for me to consider them a suitable replacement.
Yes, the AUM figures do look undernourished. It’s bad luck that value’s taken a kicking over the last several years. Hopefully you’ll be set fair if Powershares stand behind the rest of the range.
My strategy has been to go for broader global / emerging market risk factor trackers. Other than ASL which is an investment trust that focusses on UK small-value.
For anyone who’s thinking of investing in a newly launched product – I’d give it at least one year and more like two before investing to make sure it’s viable.
You don’t actually lose your money if a fund closes but you will be sold back into cash and could conceivably face a capital gains problem if you hold a large position outside of tax shelters.
Chasing Hot Returns in ‘Smart Beta’ Can Be Dumb
By Jason Zweig
http://www.wsj.com/articles/chasing-hot-returns-in-smart-beta-can-be-dumb-1455319331
I notice that iShares have two versions of this ETF. IFSW which is denominated in $ and FSWD which is denominated in £. I’ve done a comparison on Hargreaves Lansdown and over the last 3 years, FSWD has out-performed IFSW by around 20% (approx 47% vs 27%). It must be something to do with currency movements, but can’t quite get my head around it. It seems counter-intuitive, given the recent weakness of £ vs $; I would have expected the $ denominated IFSW to have been the better performer.
Hi Gizzard, the ETF’s currency doesn’t affect returns. What matters is the performance of the underlying securities vs the £. For example, your returns will be the return of the asset plus or minus its home currency vs £. If you own a dollar security and it goes up 10% in the US, and the dollar goes up 10% against the £ then you get a return of 20%, if you’re measuring your return in £. The same goes for any underlying securities in the ETF that are denominated in Euros and Yen and anything else. It’s the performance of the security + its home currency vs £ that counts.
You are likely looking at the currency which the ETF reports in. Either £ or $ in this case. £ version could look better because the £ has been weaker against other global currencies than the dollar, therefore it looks like its had a barnstormer. But in reality it holds the same assets as the $ version and the performance of IFSW would be just as good if you were seeing its returns in £.
Some good pieces here on the topic:
http://monevator.com/currency-risk-fund-denomination/
https://www.justetf.com/uk/news/etf/the-effect-of-currencies-on-etfs.html
If you look at the charts then FSWD jumped in June 2016 which makes sense because as the £ dropped on the Brexit vote then all £ demoniated global assets would have risen by the same amount so the buying power remained the same as it was the currency that took the hit and not the global asset.
I assume which one you invest in all depends on your home base currency? £ investors go for FSWD and $ investors go for IFSW so you dont leave yourself exposed to currency gambling against your base currency. Would that be correct ? Or maybe it doesnt ultimetly matter which one you go for as a £ investor ?
@ Lenahan – no, this is a common misunderstanding, You are exposed to the same currency risk regardless of whether you buy FSWD or IFSW. See my previous comment.
Fund providers have found that investors are more comfortable if their investment vehicle reports in their home currency so they provide ’em. But this has nothing to do with currency risk. It’s the equivalent of a restaurant using nice tablecloths. Doesn’t change the taste of the food but makes you feel better all the same.