Morningstar Magazine - October/November 2016 - 58

Strategies Diversifying across complementary factors makes sense. Doing so will mitigate the aforementioned cyclicality associated with owning any one factor in isolation. This could result in lower long-term returns relative to owning the single most potent factor in isolation, but that assumes, first, you know what that factor will be on an ex-ante basis and, second, you have the stomach to stick with it for decades. In my mind, perhaps the single most compelling reason to opt for a multifactor strategy is that it will minimize the biggest risk of all-that investors will bail on a factor, manager, or strategy when it experiences an inevitable period of relative underperformance. What to Look For Generally speaking, I believe that owning a multifactor ETF is preferable to trying to build a do-it-yourself multifactor model, combining single factors on one's own, for most investors. The do-it-for-me approach is far more efficient from a cost, tax, and general portfolio management perspective. Combining stand-alone factors in a multifactor format is a sensible strategy to the extent that the factors in consideration are credible, well-constructed, and combined in such a way as to improve the overall risk/reward profile of the resulting portfolio relative to owning any of the factors in a stand-alone format, a traditional cap-weighted index fund, or an actively managed peer. Most of the multifactor ETFs on offer today pass the first test above. There are few-if any- suspect factors featured in these funds, most of which select from the members of my factor A-Team. Things get trickier when assessing factor construction and the manner in which these factors are combined. My preference, as always, is to keep it simple and cheap. As I often emphasize, index construction matters! It is vital that investors parse the details of the methodologies for these funds' underlying benchmarks to understand what drives them. I have a strong preference for simplicity over complexity. The more opaque and overwrought the methodology, the more likely it is that the index is a product of back-testing alchemy and that its methodology may ultimately be revised should its live performance not live up to its back-tested track record-a record that never looks bad. And, of course, costs matter. Many of these funds, while competitively priced versus actively managed peers, have fees that are many multiples of those levied by ETFs tracking broad, cap-weighted benchmarks. Be sure you are not paying active management fees for a passively managed fund. Last, be sure to manage your expectations. These funds are no magic elixir. Many are very new and track indexes with limited live track records. No matter how sensible their underlying indexes may seem and how low their fees, there's no guarantee they will deliver better risk-adjusted returns than a plain old cap-weighted index fund over a full market cycle. Much like single factors or good active managers, these funds will experience their own performance cycles (albeit potentially more muted ones). Investors' ability to reap the prospective rewards these funds might offer is positively correlated to their ability to stick with them through their inescapable ups and downs. What's in the Mix? Now that we've made the case for multisector ETFs, let's take a look at what the market is offering investors. By my count, there are eight dyed-in-the wool multifactor ETFs in the U.S. large-cap space (E X H I B I T 4 ) . These funds are all very new. The elder statesman of the bunch, ETFS Diversified-Factor U.S. Large Cap SBUS, was launched in January 2015. These eight funds had collective assets under management of $1.4 billion as of the end of July, and just three of them held more than $100 million of investors' capital. Thus, all of the standard disclaimers about new and untested (though in this case thoroughly back-tested) strategies apply here. EXHIBIT 4 New Kids on the Block There are eight true-blue multifactor ETFs that invest in U.S. large-cap stocks, and each was launched in 2015. All have a value component, and seven of the eight add momentum. Name Inception Expense Date Ratio (%) Total Avg. Assets # of Mkt. Cap ($Mil) Holdings ($Bil) Goldman Sachs ActiveBeta US LgCp Eq ETF GSLC 09/17/15 0.09 923 429 50.7 0.95 JHancock Multifactor Large Cap ETF JHML 09/29/15 0.35 235 770 40.5 1.06 iShares Edge MSCI Multifactor USA LRGF 04/28/15 0.35 110 135 23.0 1.06 JPMorgan Diversified Return US Eq ETF JPUS 09/29/15 0.29 71 540 23.1 0.86 Global X Scientific Beta US ETF SCIU 05/12/15 0.19 65 451 21.2 0.94 Deutsche X-trackers Russell 1000 CmpsFtr DEUS 11/24/15 0.25 21 824 12.7 0.90 ETFS Diversified-Factor US Large Cap SBUS 01/26/15 0.52 8 461 - 0.93 SPDR MSCI USA StrategicFactors ETF QUS 04/15/15 0.15 6 613 60.2 0.86 Source: Morningstar. Asset and volume data as of Aug. 8, 2016. Portfolio data as of July 31, 2016. Beta measured from December 2015 to July 2016. 58 Morningstar October/November 2016 Beta

Table of Contents for the Digital Edition of Morningstar Magazine - October/November 2016