The many multifactor ETFs available to investors can largely be divided into two groups.
Both isolated/mixed and integrated multifactor ETFs look to achieve similar goals: enhance returns while diversifying sources of risk. However, the two types go about it in different ways, making it important for advisors to fully understand how each approach works.
Isolated/Mixed Multifactor ETFs
An isolated factor portfolio, also referred to as mixed multifactor ETFs, gives each individual factor a portion, or sleeve, of the portfolio. The targeted single factor could be value, low volatility, or another factor.
While an isolated factor approach to multifactor ETFs may provide the intended exposure to the targeted exposure, it also introduces another set of challenges. Factors, both at the company and portfolio level, rarely exist in isolation, according to Hartford Funds.
This creates challenges for the isolated factor approach, as it can introduce unintended exposures. For example, many funds use an equal-weighting strategy to access the size factor. However, equal weighting also tends to raise volatility and is inherently anti-momentum.
Likewise, considering value companies with high quality can help avoid distress risk, and pairing with positive relative momentum can help avoid value traps.
Integrated Multifactor ETFs
On the other side of multifactor ETF construction is an integrated approach, which selects securities that fit a number of desired factor characteristics.
In an integrated scoring approach to factor implementation, a single composite score comprises the factor scores at the company level. The integrated scoring approach aims to improve the strength and balance of overall factor exposure within a portfolio.
An integrated factor scoring approach generally results in higher factor expression and higher average monthly spread returns than an isolated approach, according to Hartford Funds.
Furthermore, the difference between the two methodologies is even more pronounced across developed international and emerging market universes, according to Hartford Funds.
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