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The Rise of Multi-factor Smart Beta ETFs

Multi-factor ETFs are marketed as a way of improving investor return profile by addressing the risks inherent to single-factor smart beta funds

Ben Johnson 22 September, 2017 | 10:53AM

The European strategic-beta ETP market has continued to experience strong growth, with assets under management up by 38% to a new high of $56.2 billion in the 12 months to June 2017. The bulk of these gains have been driven by a largely uninterrupted stream of positive inflows, amounting to $10.1 billion. Strategic-beta ETPs have continued to claim market share from their more mainstream peers.

Dividend  strategies remain the most popular, thanks to the ultra-low interest rate environment

In the 12 months to the end of June 2017, strategic-beta ETPs’ market share increased to 8.1% from 7.6% as of end-June 2016, further extending the steady positive growth trend observed since 2009. While dividend weighted ETFs retain the lion’s share of overall assets invested in strategic-beta ETPs, multi-factor ETFs are fast becoming a key growth segment.

In the 12-month period to the end of June 2017, a total of 47 new strategic-beta products hit the shelves. The better part of these entrants was based on multifactor indices. The rise of multi-factor combinations is facilitated by product crowding in the single-factor equity space.

The latter is showing classic signs of saturation, with new entrants now mostly filling in missing geographical coverage. For example, in the first half of 2017, European providers launched only four new single-factor ETFs, targeting geographical exposures such as Japan – BNPP E iSTOXX MUTB Japan Quality 150 ETF and WisdomTree Japan Equity ETF.

What are Multi-factor Smart Beta ETFs?

Multi-factor ETFs are marketed as a way of improving investor return profile by addressing the risks inherent to single-factor smart beta funds. We are seeing an evolution in product development on this front. The first batch of multi-factor ETFs tended to follow an equal-weighted approach to combining several factors.

Now, their construction is moving to a combination of a “core” factor exposure, which is enhanced by a single or a combination of additional factors. Quality-dividend indices are the prime example of this practice, where the dividend-paying companies must be more profitable and less indebted to be included in the index portfolio.

Another popular range of products use low volatility as their “core” factor exposure and complement it with quality, value, and/or momentum. It is fair to expect more products of this type to come to market.

After all, multifactor ETFs can be churned in many different combinations. Despite losing prominence in terms of product development, single-factor ETFs continue to retain the greatest market share in the European strategic-beta marketplace.

Dividend ETFs Remain the Most Popular

In particular, dividend-screened strategies remain the most popular segment, accounting for 39% of total strategic-beta ETP assets. Their appeal continues to be underpinned by the confluence of ultra-low interest rate environment and a growing base of yield-hungry investors.

By contrast, low volatility/minimum variance single-factor strategies have seen their market share of the strategic-beta ETP universe drop to 13% from 19% in the previous period. These strategies have recently underperformed cap-weighted benchmarks even in Europe and emerging markets. Two probable reasons to explain this behaviour are the on-going rotation to value and momentum factors and the attempts to reduce interest-rate exposure, as low volatility stocks tend to underperform in rising-rate environments.

Despite the buzz of expectation surrounding the prospects for strategic-beta fixed-income ETFs in Europe of late, it is an area that remains remarkably under-cultivated. The first wave of products, proposing a quality approach to the bond market by means of using standard macroeconomic-magnitude-defined filters, has failed to make inroads in a market starved for yield. Many providers are taking a long look at the fixed income space. However, developments are few and far between, not least as there is no consensus view on whether the factors that we know so well in equity investing can be applied to fixed income.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author Ben Johnson

Ben Johnson  is director of passive funds research at Morningstar.