The evolving use of equity factor ETFs

Single and multifactor ETFs can serve a variety of roles in a diversified portfolio ranging from short-term tactical adjustments to long-term strategic allocations. Here are some key things to know about them.

Single factor ETF use cases: Portfolio building blocks

Because of their unique tilts and weighting methodologies, factor-based strategies can increase portfolio diversification with historically low excess return correlations. The low excess return correlations can make single factor ETFs effective portfolio building blocks and can be used in a variety of ways, including:

Core allocation

Some investors choose to invest in single factor strategies as part of their core equity allocation. They can choose to overweight offensive or pro-cyclical factors when they expect the equity market to perform well or defensive factors in periods of equity market weakness.

Core/satellite approach

Investors with a limited tracking error budget may choose to invest a large percentage of their equity portfolio in low cost, broad market funds. They can use factor ETFs as satellite investments in hopes of improving risk-adjusted returns.

Adjusting portfolio exposures

Single factor ETFs can also be used to adjust exposures at the total equity portfolio level. An investor may have identified a group of relatively high-risk active managers that they’d like to keep in their portfolio. If they want to reduce the expected risk of the total portfolio, they may consider an allocation to a defensive factor like low volatility or quality.

Multifactor investing: A range of options

Although single factor ETFs have a place within many portfolios, they can be highly cyclical and experience significant tracking error to the broad market. Multifactor ETFs may offer a range of potential benefits, including increased diversification, lower historical drawdowns, and improved risk-adjusted returns. One useful framework for analyzing multifactor funds is through the lens of expected tracking error. Invesco offers a range of options to cater to different investor risk tolerances and objectives. 

On the lower end of the expected tracking error spectrum are multifactor strategies that eliminate a small percentage of stocks exhibiting the lowest factor characteristics from a parent index. The remaining positions are weighted by market capitalization. Invesco developed a suite of low tracking error multifactor ETFs including the Invesco S&P 500 QVM Multifactor ETF (QVML), Invesco S&P 400 Multifactor ETF (QVMM), and Invesco S&P 600 Multifactor ETF (QVMS). (See table below.)

On the higher end of the expected tracking error spectrum are multifactor strategies that dynamically rotate between factors. This approach may be appropriate for higher conviction investors willing to assume greater tracking error and potentially replace an active manager with a lower cost alternative. The Invesco Russell Dynamic multifactor suite of ETFs, including the Invesco Russell 1000 Dynamic Multifactor ETF (OMFL), are examples of factor rotation strategies. (See table below.)

Overall, our analysis finds that investors are driving significant demand for both single and multifactor ETFs within their portfolios.

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