Investors continue to focus on factor investing as more ETF issuers launch single and multi-factor ETFs that target risk premiums through rules-based indexing. Multi-factor ETFs are particularly popular as advisors evaluate the merits of using them in place of traditional active management.
Despite the promise of combining multiple factors into a single portfolio exposure, many of these indices (and their ETF counterparts) are constructed differently and deliver their promises in varied ways. This can lead to questions during the due diligence process, including:
• How much exposure results from each factor being targeted in the portfolio?
• How consistent is the construction of these portfolios with the typical behavior of an active manager?
To answer these questions, we’ll review the current index construction methods for multi-factor ETFs to identify similarities and differences. We will also derive an alternative construction approach based on Bayesian statistics to capture how active managers incorporate factors into their decision-making. Finally, we will compare hypothetical portfolios based on each construction method to compare and contrast their risk and return properties.