A Scientific Approach To Multi-Factor Investing

A steady stream of multi-factor exchange traded funds have been coming to market for over a year now. Multi-factor ETFs offer investors exposure to several investment factors – the idea being that investors don't need to time when a certain factor will perform well and when others will fall out of favor.

The Global X Scientific Beta US ETF SCIU, which is 14 months old, has proven, in real time, the advantages of the multi-factor structure. SCIU is part of a suite of Global X ETFs that follow “EDHEC-Risk Institute indices that target multiple factors, including low-volatility, momentum, size and value. The indices also combine the five models, including Maximum Deconcentration, Maximum Decorrelation, Efficient Minimum Volatility, Efficient Maximum Sharpe Ratio, and Diversified Risk Weighted,” according to ETF Trends.

Global X's other multi-factor ETFs based on the EDHEC-Risk Institute indices are the Global X Scientific Beta Europe ETF SCID, the Global X Scientific Beta Asia ex-Japan ETF SCIX and the Global X Scientific Beta Japan ETF SCIJ.

Year-to-date, SCIU is outpacing the S&P 500 by nearly 200 basis points, which some onlookers might attribute to the ETF's low volatility exposure. A deeper look reveals some intersection of the low volatility and momentum factors.

“ERI Scientific Beta defines the momentum factor as the past 52-week returns, excluding the most recent month. To construct their U.S. Momentum factor index, Scientific Beta begins with a starting universe of the 500 largest stocks in the U.S. by free float market cap and then selects the 250 with the highest 52-week returns, excluding the most recent month. Using a similar process, ERI Scientific Beta constructs its low volatility index by starting with the 500 largest stocks in the US by free float market cap and selecting the 250 stocks with the lowest 104-week volatility,” according to Global X research.

SCIU's sector weights indicate that the ETF does dwell in both the low volatility and momentum spaces. While not a dedicated low volatility ETF, SCIU has some of the hallmarks of traditional low volatility ETFs with a combined weight of about 45 percent to financial services, utilities and consumer staples stocks.

Conversely, the ETF cover its momentum bases by allocating nearly a third of its combined weight to consumer discretionary, healthcare and technology stocks. Rising correlations between the low volatility and momentum factors underscore the utility of multi-factor strategies.

“Those with exposure to both Momentum ETFs and Low Volatility ETFs are moving closer to potentially doubling down on Low Volatility stocks, and may not be as diversified across factors as originally thought,” according to Global X.