Do multi-factor ETFs have it all? A clear investment process? Check. Low management fees? Check. And now, with the iShares Multifactor Equity ETFs, they’re claiming sustained outperformance too.
The evidence for this last point? Strong three-year track records plus 15 years of backtested outperformance, as published by index provider MSCI.
It certainly begs the question ‘Can investors truly have it all?’ We turned to holdings-based analytics specialist Windfactor Research in search of an answer.
President, Windfactor Investment Research
Traditional active quant products packaged in transparent index funds, such as the iShares Edge MSCI Multifactor USA ETF (LRGF) or the iShares Edge MSCI Multifactor Global ETF (ACWF), can deliver as-good-or-better returns – assuming investors find the same attributes attractive going forward and remain slow to act on new information.
Under those assumptions, this year looks promising for these funds. For example, the current Windfactor for LRGF is 66, suggesting 2:1 odds that this year’s returns will be above the total US market (and, presumably, above the MSCI USA index, which the fund is designed to outperform).
How they work
According to their literature, the iShares Multifactor ETFs diversify across sectors but systematically tilt toward value, size, momentum and quality factors. Within the universe defined by the MSCI USA index, for example, LRGF will invest in stocks that have smaller market capitalizations, lower P/E ratios, higher recent returns, higher reported return-on-equity, lower debt and lower earnings variability. A stock doesn’t need all of those attributes to be included, but the index construction rules clearly favor names that boast several of them.
After each reconstitution, the funds hold for six months – longer if a firm’s characteristics don’t change – which keeps turnover low. More importantly, it gives ample time for investors who favor similar companies but who are slower to act to come along and bid up prices. Since most stock pickers screen for at least some of the same characteristics, odds are that they will pick something the ETF has already bought.
Historically, these price-pumping investors have always come along. The bubble chart below shows the active returns for the US and Global MSCI factor indices underlying LRGF, ACWF and their single-factor counterparts. With annual information ratios of 0.67 and 0.93 respectively, both the US and Global multi-factor indices have posted higher risk-adjusted returns than any single-factor index. These results are notable given the poor performance of value indices over the period, highlighting the ability of a multi-factor strategy to keep flying when one of its engines shuts down or explodes completely, as momentum did during the 2009 recovery when the US index lagged by 9.5% and the global index by 15.6%. The worst underperformance for other single-factor indices in a single year has ranged from 3.1% to 9.1% below the parent index. Comparatively, average underperformance for the multi-factor indices was a mere 2.5%.
Will they keep working?
Assuming no significant market changes, it seems likely that investors will continue to look for companies with similar characteristics. The biggest risk going forward might be the shift from slow-moving stock picking to systematic investing, leaving today’s front-runners at the back of tomorrow’s pack.
There is also always a risk of too many investors overheating a strategy, particularly if heavy leverage is applied. However, Windfactors provide an early warning indicator, dropping as higher prices signal lower prospective returns. Judging by the latest numbers, that hasn’t happened so far for the iShares Multifactor funds.
What they are:
The statistical probability (0 – 100) that a fund will outperform the US market over the next 12 months given past market conditions.
How they’re built:
The historical risk-adjusted returns of similar companies with similar starting prices, as calculated by Windfactor’s unique business factor models. These best-match returns are reported in percentages relative to the broad US market.
Why we care:
Windfactors predict actual fund returns whenever history repeats itself. Research suggests that systematically investing in funds with higher Windfactors would have been a good bet over the past decade.