Strategic Beta Introduction Series (Part 2)

Multi-factor ETFs aim to address this issue of factor cyclicality. By combining factors, multi-factor strategies offer a smoother ride through market cycles, reducing the risk of investors abandoning sound strategies at precisely the wrong time.

With multi-factor ETFs, it’s important to understand not only how the individual factors are built, but also how they are put together, as different approaches will lead to different outcomes.

Momentum
Momentum is one of the best-known factors in investing. Momentum investing is about buying winning stocks, stocks that have done well in the recent past, and selling losing stocks, stocks that have done poorly. Academic research shows that stocks that have recently risen or fallen in price will continue that trend over the short-to-medium term, typically over six to 12 months. And over the long term, high-momentum stocks will outperform the market.

The idea is quite simple, but the implementation is difficult. And a badly-implemented momentum strategy can result in poor performance. Momentum is one of the most challenging factors to exploit.

One issue with momentum strategies is their transaction costs; they have relatively high-levels of turnover. Investors seeking to capture the momentum premium can turn to ETFs. But as always, it's important to understand the methodology that each fund uses to select its holdings.

Quality
Quality is a fuzzy factor. There is no one definition for quality, nor is there clear consensus that it is a true stand-alone factor. Typically, a quality company is more profitable, financially healthy and offers stable earnings over time relative to its average competitor. These tend to be mature businesses with sustainable competitive advantages like Microsoft, Unilever and AstraZeneca.

Research suggests that stocks with higher-quality characteristics have historically offered better risk-adjusted returns than lower-quality stocks.

Investors considering quality-focused funds are best advised to check valuations before making their portfolio selection decision. Quality stocks tend to come at a premium and they are not necessarily good investments at any price.

Dividend
As their name suggests, in their simplest form dividend ETFs select stocks which have the highest expected dividend yield. The allure of strong income streams in the current low rate environment has helped them become the most popular strategic beta strategy in Europe, currently hording around a quarter of assets under management.

Beyond simply providing an income, dividends matter because they can be used by managers to signal their confidence in their firms' prospects and can impose greater discipline on their capital-allocation decisions. As such, higher yielding stocks are often seen as being higher-quality and more stable than their peers.

Although a simple approach can be effective, especially when implemented in a diversified way such as with the Vanguard FTSE All World High Dividend Yield ETF (VHYL, listed in Europe) – in other cases such as the iShares DivDAX (EXSB, listed in Europe), the low number of holdings leaves the fund particularly susceptible to dividend traps. In this case high yield can actually signal financial distress, making some of the highest yielding stocks more likely to cut their dividends than their lower yielding counterparts.

To protect against this, some funds go one step further and introduce additional screens to ensure sustainability. The SPDR S&P Dividend Aristocrats (GBDV, listed in Europe) series only includes stocks which have shown a consistent pattern of maintaining or increasing dividends for at least 10 consecutive years.

Others such as the Amundi MSCI Europe High Dividend Yield (CD9, listed in Europe) adds profitability and other quality screens.

Given the quality attributes connected with high yielding stocks it should not come as a surprise that they are considered defensive and expected to perform best in bear markets.