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‘With passive investing you’re off-roading with volatility and with multifactor, you’re looking at a smoother road,’ says Stan Wong of ScotiaMcLeod.

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The rapid growth in the number of multifactor exchange-traded funds (ETFs) during the past couple of years could be a boon to financial advisors.

That’s the message from Daniel Straus, vice-president of ETFs and financial products research at National Bank Financial Inc. in Toronto. Mr. Straus co-wrote his firm’s “Multi-Factor ETF Review” report, published on Jan. 25, which notes that “Canadian multifactor ETFs have recently exploded in number: more than 20 launched since 2017.”

“I believe that many of these ETFs were constructed with the advisor community in mind,” says Mr. Straus, adding that many advisors are turning to these products to infuse active management into clients’ portfolios without high fees.

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The recent rise to prominence of multifactor ETFs illustrates just how far ETFs, in general, have evolved, he says.

“For a decade, ETFs were synonymous with passive index investing,” Mr. Straus says.

Then came thematic products focused on specific industrial sectors and geographies. Active management products were next, and then single-factor ETFs. Multifactor ETFs are the latest iteration. They employ variety of investment strategies that include value, momentum and quality – to name a few – and are designed to provide enhanced performance and risk management over passive approaches tracking broad-based indices.

Additionally, by combining multiple strategic overlays under one umbrella, multifactor ETFs aim to provide superior returns compared with single-factor ETFs.

“It’s our belief – backed up by decades of investment research – that there are factors that can help you consistently outperform an index,” says Dennis Tew, head of national sales at Franklin Templeton Investments Canada in Toronto.

That’s why the company, a mutual fund giant, launched a suite of four multifactor ETFs – all marketed exclusively to advisors – in addition to its existing lineup of active and passive products.

Mr. Tew points to the recent performance of Franklin Templeton’s multifactor Franklin LibertyQT U.S. Equity Index ETF (FLUS), the total return of which was 2.68 percentage points higher than that of iShares Core S&P 500 Index ETF (XUS) – a passive strategy instrument – for the year ended Dec. 31.

“Its secret sauce is the same as our other multifactor ETFs,” says Mr. Tew, adding that all four of Franklin Templeton’s multifactor ETFs incorporate four factors: quality, value, momentum and low volatility.

Each screen is weighted based on the guidance of “a team of PhDs” with the goal of better risk-adjusted returns over market cap-weighted and single-factor strategies, he says. The typical allocation is roughly as follows: 50 per cent of assets are weighted to quality, 30 per cent to value, 10 per cent to momentum and 10 per cent to low volatility.

Stan Wong, director, wealth management, and portfolio manager at ScotiaMcLeod Inc. in Toronto is an early adopter of multifactor ETFs, including Franklin Templeton’s offerings.

“The way I look at passive indices – traditional ETFs – is that they can be flawed in terms of market weighting or be overexposed to a particular factor following periods of outperformance,” he says. “So, for example, last year, growth and momentum did very well until the last few months.”

By contrast, value and quality did better at the end of 2018. What’s more, single-factor ETFs would have come with their own set of challenges.

“If someone is all in on momentum and growth, that’s great when those kinds of stocks are doing well, but the wheels kind of fall off” when markets get skittish like they did in the last quarter of 2018, Mr. Wong says.

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Although Mr. Wong adds that the returns of multifactor ETFs may not be significantly better than passive and single-factor products, that’s beside the point, he says. Their true purpose is reducing volatility.

“With passive investing, you’re off-roading with volatility,” he says, “and with multifactor, you’re looking at a smoother road.”

Even if returns turn out the same over time, reduced volatility is important because wild price swings prompt panic calls from clients, he adds.

Nevertheless, Robyn Graham, managing director and portfolio manager at ETF Capital Management in Toronto, argues that multifactor ETFs don’t offer advisors anything they don’t already have access to.

“We prefer using single-factor ETFs so we can choose which factors to use rather than combining them, as this fits better with our active style,” says Ms. Graham who acknowledges the multifactor approach is likely a good fit for advisors who favour less active strategies.

Mr. Straus agrees, suggesting investment professionals who have built their businesses using passive portfolio strategies are now finding their practices increasingly threatened by the growing popularity of passive ETFs.

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“Clients might ask, ‘What am I paying you for when I could do this myself?’,” he says.

Multifactor ETFs provide advisors with answers.

“[Advisors] can say, ‘I can build you a core of passive, low-cost ETFs and then complement it with multifactor ETFs that cost a little bit more, but are still much cheaper than mutual funds while allowing you to compound a little bit more than purely passive approaches’,” Mr. Straus says.

Then again, Mr. Straus cautions whether multifactor ETFs are indeed superior to other strategies is unclear given their short track records.

“I still think we’re in the very early days [for these products].”

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