In recent years, investors have increasingly turned to factor investing as a way to diversify their portfolios and potentially achieve higher returns. Factors are specific characteristics of stocks that have been shown to contribute to long-term outperformance, such as low volatility, high quality and value.
Multi-factor exchange-traded funds (ETFs) combine two or more of these factors into a single investment product, providing investors with diversified exposure to a range of factors. In this article, Benzinga explores the basics of multi-factor ETFs, the benefits and risks of investing in them and how to choose the right ETF for your investment goals.
What Are Multi-Factor ETFs?
Multi-factor ETFs combine two or more factors into a single investment product. Factors can include value, growth, quality, momentum, low volatility and others. By combining multiple factors, investors can gain exposure to a diversified portfolio of stocks that have been shown to outperform over the long term.
The construction of multi-factor ETFs can vary depending on the provider, but typically, the ETF will hold a portfolio of stocks that exhibit the desired factors. For example, a multi-factor ETF may hold stocks with high quality and low volatility, or stocks that feature value and momentum.
Benefits of Multi-Factor ETFs
Diversification: Multi-factor ETFs provide investors with a diversified portfolio of stocks that have been shown to outperform over the long term. By investing in a range of factors, investors can reduce their exposure to individual stock risks and potentially improve their risk-adjusted returns.
Outperformance: Research has shown that certain factors, such as value and momentum, have historically outperformed the market over the long term. By investing in a multi-factor ETF that combines these factors, investors can potentially achieve higher returns than the overall market.
Simplicity: Multi-factor ETFs provide investors with a simple and cost-effective way to gain exposure to a diversified portfolio of stocks. Unlike traditional active management, which requires extensive research and analysis, multi-factor ETFs offer a rules-based approach that seeks to capture the desired factors.
Risks of Multi-Factor ETFs
Factor concentration: While multi-factor ETFs provide investors with diversified exposure to a range of factors, some ETFs may be heavily concentrated in certain factors. For example, a multi-factor ETF that combines value and momentum may hold a large percentage of stocks in the financial sector, which could increase the ETF's exposure to sector-specific risks.
Lack of customization: Multi-factor ETFs provide investors with exposure to a predefined set of factors, which may not align with an investor's specific investment goals or risk tolerance. For investors seeking a more customized approach, individual factor ETFs or a combination of factor ETFs may be a better option.
Frequently Asked Questions
What are the benefits of investing in multi-factor ETFs?
Multi-factor ETFs offer investors the potential to achieve enhanced risk-adjusted returns compared to traditional index funds by combining multiple factors that have historically shown to outperform the broader market.
What factors are typically included in multi-factor ETFs?
The factors included in multi-factor ETFs can vary but typically include value, momentum, quality and size. Some multi-factor ETFs may also include additional factors, such as low volatility or high dividend yield.
How do I choose the right multi-factor ETF for my investment portfolio?
When choosing a multi-factor ETF, consider your investment objectives, risk tolerance and investment timeframe. Look for an ETF that aligns with your investment strategy and that has a track record of consistent performance.
Can I invest in multi-factor ETFs through my retirement account?
Yes, multi-factor ETFs are available through most retirement accounts, including 401(k)s and IRAs. Check with your retirement account provider to see if multi-factor ETFs are an available investment option.
Are multi-factor ETFs suitable for all investors?
Multi-factor ETFs can be a suitable investment option for investors with a moderate to high risk tolerance and a long-term investment horizon. As with any investment, it is important to consider your individual circumstances and consult a financial advisor before making investment decisions.
Do multi-factor ETFs have higher fees than traditional index funds?
Multi-factor ETFs may have slightly higher expense ratios than traditional index funds due to the additional research and analysis required to construct the ETF. However, the potential for enhanced returns may justify the slightly higher fees for some investors. Be sure to compare expense ratios and consider the potential benefits of each ETF before making a decision.
Can multi-factor ETFs be used for diversification in a portfolio?
Yes, multi-factor ETFs can be used as a diversification tool in a portfolio. By combining multiple factors in a single ETF, investors can achieve diversification across different investment styles and sectors.
Are there risks associated with investing in multi-factor ETFs?
Like any investment, multi-factor ETFs carry risks, including market volatility and the potential for losses. Additionally, because multi-factor ETFs are constructed based on historical data, there is no guarantee that they will continue to outperform the broader market in the future. It is important to consider your investment objectives and risk tolerance before investing in an ETF.