The best way to use factor ETFs

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Multifactor exchange-traded funds have proliferated in recent years. Joining me to discuss the thinking behind them is Ben Johnson. He is director of global exchange-traded fund research for Morningstar.

Ben, thank you so much for being here.

Ben Johnson: I'm glad to be here. Thanks, Christine.

Benz: Ben, in your most recent issue of ETFInvestor you looked at some of these multifactor products, but you really delved into the philosophy behind why someone might want a multifactor portfolio. Let's start though a step backward and talk about what is a factor when it comes to investing?

Johnson: That's a terrific question. I think one of the best ways to think about factors is to draw an analogy, and I'm going to borrow an analogy here from Andrew Ang. Andrew was a professor at Columbia, now works for BlackRock and literally wrote the book on factors. And he makes a comparison between factors and nutrition. So factors are to assets like stocks and bonds as macronutrients are to food. So, if you take food, a hamburger, a sandwich, what have you, there are basic macronutrients that are the constituents that make up that food--fat, protein, carbohydrates, fiber, and water.

So, when we think about assets, what drives assets' returns are, also like in the case of food, sort of macronutrients. The biggest typically being market beta, but there are other factors that we've discovered over time that academics have isolated and vetted that are incremental to just market beta, things like value, things like momentum, quality, volatility, inflation. These are the various components of assets' returns that drive them in isolation, that explain the differences in different types of assets' returns. We can decompose them into these fundamental factors.

Benz: OK. So, you had a great chart in the article where you looked at the performance of some of these factors in isolation, things like quality and valuation and so forth. And you sort of stacked them up and when you compare them to market-cap weighted global index, you showed that these factors did, in fact, outperform over this nearly 30-year period that you examined. So, let's talk though about how the factor outperformance was really quite cyclical, that it wasn't that necessarily that all factors performed well all of the time.

Johnson: That's an important point to note because as you highlighted, Christine, over a very long period of time if you give any one of these factors long enough, what we've seen historically is that they've provided superior absolute returns relative to a market cap-weighted index. In virtually all cases they've also provided better risk-adjusted returns relative to a market cap-weighted index. But over that very long stretch of time each of these factors has experienced its own unique cycles. They've seen long periods of outperformance. They've seen extended droughts relative to the cap-weighted index. So, one's ability to enjoy those excess returns, that better risk profile, is intrinsically tied to their ability to stick with that particular factor throughout those stretches of underperformance in particular in order to enjoy those periods of outperformance.

Benz: When you look at the specific factors that have outperformed, one factor that jumps out in your graphic was that quality cut of the global market has performed really well over the past nearly 30-year period. So why shouldn't investors just back up the truck for quality and forget all the other factors which haven't performed quite as well?

Johnson: Because even in the case of high-quality firms--so firms that are highly and very consistently profitable, that are well-managed, that have squeaky clean balance sheets, firms that fit into a bucket that we at Morningstar would label as having sort of wide economic moats--are going to experience periods where they will underperform. A perfect case in point would be in the runup of the technology bubble where quality was not exactly something that people were seeking out. They were seeking out what's going to be the next Pets.com. So, while quality is measured by the relevant MSCI index that I looked at was the best performing of the bunch, again, one's ability to enjoy those long-term excess risk-adjusted returns is contingent upon their ability to stick with it when it looks unpopular and they might feel ashamed to talk about that particular strategy at a cocktail party where all their friends are chattering about what's going to be the next Pets.com.

Benz: Right. So that's really where you get to this idea of combining factors, that just as you would diversify other things in your portfolio, that if you're thinking about factors in your portfolio that you'd think about, kind of, spreading your bets around a little bit?

Johnson: Absolutely, and I will bring it back to the nutrition analogy. So, just as you wouldn't go out and set out to have a diet that consisted entirely of carbohydrates, it's advisable to have some sort of balance among these various factors to diversify, to take advantage of what is the only free lunch in investing, which is diversification. So, if you're going to try to harness these factors to not put all of your eggs in one factor basket, but combine them in a way that makes sense, that will mitigate those ups and downs relative to owning any one of them in isolation.

Benz: So you think it's a good idea to consider one of these multifactor exchange-traded funds or some sort of product that bundles multiple factors together rather than sort of setting out on my own--and you can do this now because there are ETFs that focus on specific factors--you think it's better to consider one of these multifactor products versus trying to, kind of, build my own?

Johnson: I think it's important to note, too, that a lot of these single factor ETFs that are available on the marketplace today were in many cases created for very specific clientele. Some of them were initially seeded by large institutional investors who have their own models, who have their own strategies and are looking to very finely and very precisely manage their exposure to these different factors on an ongoing basis. So, for an individual to look at those narrower implements and say, I'm going to do it myself here and try to combine these on my own, I think it's inefficient, it's difficult, and in all likelihood will wind up being quite costly. So, to the extent that there are very sensibly constructive multifactor ETFs out there that will do it for you, combine them for you that are more efficient, less costly, and certainly, will be more tax-efficient as they all reside under one roof as well, I think that's a more sensible approach.

Benz: I guess a related question though is, if I own some sort of a product that is focusing on multiple factors, is there a risk that I'm going to end up with something that looks and feels and behaves a lot like that market-cap weighted index that I was trying to outperform?

Johnson: And there's a real risk there. I mean, if anything, the total stock market is the ultimate multifactor portfolio. It is the ultimate multitheme portfolio. It owns everything all at the same time and allocates according to going market values. So there is absolutely that risk. So, it's important to understand how the indexes underlying these ETFs are built, how they are different from owning a broad cap-weighted portfolio and as always, I have to come back to the theme of costs here, that the hurdle, that the opportunity cost of being wrong by owning a multifactor ETF as opposed to owning a cap-weighted ETF in isolation is as low as possible. So what you see is, in many cases, these funds charge fees that are a fraction of those levied by actively managed funds in their same categories. They may be many multiples the fees charged by a total stock market index fund. So it's important to understand what you're paying and whether or not you are ultimately getting value for money with regard to the fee that you pay for these exposures.

Benz: A related question is, if I'm looking across factors and looking at which factors have performed best and worst, could one reasonably look at those factors that haven't performed super well in the recent past and maybe put a few more of my eggs on those factors like value, for example, which we've talked about has been not a particularly strong performer recently? Would that be a rational thing to do?

Johnson: When you talk about looking at factors that haven't performed well lately and potentially sort of veering in that direction, I think we're veering in the direction of market timing, which we've seen time and time again is awfully difficult to do, to do well once, and certainly, to do well more than once is exceedingly difficult. So I think investors should proceed by making diversified factor bets and not trying to time individual factor bets because there's no telling when these cycles will ultimately turn, and timing is just exceedingly, exceedingly difficult.

Benz: Ben, interesting topic. Thank you so much for being here to discuss it with us.

Johnson: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.