Young & Invested: Are these the smartest type of ETFs?

Welcome to my column, Young & Invested, where I discuss personal finance and investing for Gen Z and Millennials.

This column aims to be a resource for young investors navigating an ever changing financial, political and social landscape as they try to build wealth. Tune in every Thursday for the latest edition.

Edition 29

There are around 400 ETFs listed on the ASX.

At this point, I’d like to think I’ve scratched the surface of maybe 5% of them. The reality is that new products are multiplying faster than we can keep up. We’re being inundated and suffering from the paradox of choice.

Whilst the rising popularity of broad market ETFs is undeniable, humans are flawed in that we’re always chasing something new and shiny. Our brains crave novelty. Just like a dog’s relentless efforts to sniff every tree or run up to strangers in a park – we’re also wired with a similar perceptual curiosity. This disposition helped humanity survive and progress to the point we’re at, but it’s also what makes us poor investors sometimes.

As a retail investor working in the financial industry, there’s always something new to explore. Whether it’s crypto, the price of gold or the passive vs active ETF debate – some weeks the content writes itself. This week it’s time for multifactor ETFs to take the spotlight.

Whilst the strategy isn’t new by any means, the product has been gaining traction amongst investors seeking more than just broad market exposure. The pitch is quite simply really. Instead of owning everything, wouldn’t it be better to just own the right things? In this case, it’s companies with desirable characteristics on a risk-adjusted basis.

Such products ring the novelty-seeking bell in our brain, promising a smarter way to invest with better returns and a more scientific approach to portfolio allocation. But is this just another shiny product in a sea of tickers?

What is factor investing?

A key component of understanding factor investing is the relationship between risk and return. Higher potential returns are associated with greater risk, coining the term ‘risk premium’. This refers to the extra return an investor can expect to earn above the risk-free rate (an investment with ‘no risk’ aka government bonds). The risk premium is compensation for taking on the additional risk.

Where how factors come into play?

Factors refer to select characteristics that help explain investment performance. A ‘factor risk premium’ is the extra return we get by tilting our portfolios towards companies with certain traits like value (undervalued) or size (market capitalisation).

To spare readers from an unwelcome history lesson, I’ll keep the background info short. The evolution of factor-based investing was theorised from the Capital Asset Pricing Model (CAPM) and consequent academic extensions. CAPM was established in the 60s and proposed that the ‘market factor’ (broad market risk) was the primary driver of asset returns. But this approach failed to fully explain why certain companies consistently outperformed.

Ten years later, economist Stephen Ross introduced the idea that more than one factor could explain asset returns in his paper on Arbitrage Pricing Theory. Then another two decades later, enter scholars Eugene Fama and Kenneth French, who developed the Fama French or 3-factor model.

This expanded upon existing research to conclude that on top of market risk, a company’s size and valuation were also key factors that drove returns. The model has been revisited frequently by other academics and even Fama and French themselves have since revised it to a 5-factor model.

Thus, the birth of factor investing. This strategy screens specific companies by how they correspond to desirable characteristics like quality, value, size, momentum and volatility.

Whether or not you realise it, you’re likely already a factor investor. Even if you’ve never heard of the term, your portfolio likely reflects exposure to certain factors. For example, if you own a broad ETF that tracks the ASX 200, you’re tilted towards the size and momentum factors because of the way the index is composed.

What are the factors?

Since we can’t control broader macroeconomic factors such as inflation or interest rates, we’re more concerned about style factors, specifically related to companies. Whilst we can attribute asset returns to many style factors, only a few have stood the test of time.

A 2020 study Empirical Asset Pricing via Machine Learning aimed to use machine learning vs classic regression-based models to predict risk premiums. They investigated nearly 30,000 individual stocks over a 60-year period with 94 characteristics for each stock. When extracting performance commonalities, all methods agreed on a fairly small set of dominant predictive signals: momentum, volatility, liquidity variables (size) and valuation ratios (quality).

Unfortunately, it would probably take me several editions of this column to explore the factors in the detail they deserve but below is a brief overview of why each command a premium.

Quality

The quality factor refers to companies with higher return on equity, low debt and stable earnings outperforming the broader market. These are fundamentals that Benjamin Graham – affectionately known as the father of value investing – outlined in his book The Intelligent Investor. Graham argued that such companies showed resilience during downturns and would recover to previous highs quicker than others. Admittedly, the ‘risk’ associated with such companies isn’t immediately clear unless we use an all-things-considered-equal approach. If a quality, profitable company is priced the same as a less profitable one, this indicates that the market is pricing in some level of risk.

Value

If you’ve consumed any financial content over the past few years, you’d know that historically elevated valuations have been the subject of many doomsday predictions, plaguing the minds of investors. Value stocks are typically priced lower than their intrinsic value, signalling market apprehension. Given the lower valuation, the upside can be substantial, creating a value premium for contrarian investors.

Momentum

This is perhaps the most logical factor. These are companies that have performed well in the recent short-term and tend to continue to do so. The momentum factor premium is one of the largest but is subject to sharp sensitivity from market reversals. The risk warrants the existence of a momentum premium.

Low volatility

Counterintuitively, companies with historically lower volatility have been shown to outperform in the long term. Given they’re resilience during market fluctuations, they lose a lot less and recover faster. Despite this, investors tend to be attracted to high-risk, high-reward companies meaning low-volatility stocks are underpriced.

Size

Smaller companies naturally carry more risk given their sensitivity to the economic cycle and uncertainty around earning prospects. In addition, they tend to be less liquid with limited coverage and thus can be subject to pricing inefficiencies.

It’s important to note that these factors are no guarantee of outperformance. Even though they may have enjoyed higher returns in the past, they can also be subject to extended periods of underperformance and cyclicality depending on market conditions. Factor investing requires patience, discipline, and a solid understanding of what you’re betting on.

Multifactor ETFs

Factor investing has largely been democratised through the rise of ETFs. What was once a complex strategy executed by institutions and their army of quants, is now accessible to everyday individuals.

Despite select factors being proven to provide better risk adjusted returns over time, research has found that no single one consistently outperformed across all market conditions. For example, the size factor – a return premium for owning smaller stocks relative to large stocks – has perpetually underperformed over the last two decades.

US small caps lagging. Morningstar. Data as of 14 August 2025.

The solution? Combine them into a multifactor strategy to reduce exposure to cyclicality. Rather than bet on a single one, multifactor models help smooth returns whilst avoiding long droughts customary to single factors.

In terms of wider ETF strategy, multifactor ETFs are an interplay of passive and active strategies, catering to the goals of both. They are often touted to adopt a ‘smarter’ and more thoughtful approach to broad-market ETFs. This combines the low-cost nature of passive funds, with an added active approach to an index.

However, unlike actively managed funds where a manager handpicks the underlying holdings to target an outcome, multifactor ETFs track an index, but overlay a systematic, rules-driven selection process to determine which companies best reflect relevant factors.

Benefits

I think there are obvious advantages to a multifactor approach vs single factor. As we see in the figure below, factors tend not to have high correlation with each other.

Source: Morningstar. April 2025.

This means they can offer strong diversification benefits when combined in a portfolio. An example of this is the Morningstar Global Multifactor Index, which combines value, momentum, quality, and low volatility. This multifactor index has historically had lower tracking error relative to single-factor indexes when compared to parent benchmark Morningstar Global Target Market Exposure Index.

For long term investors who will likely see several economic cycles, a multifactor approach may fare best given the changing macro conditions that have historically favoured select factors over others.

Source: Blackrock. 2024.

What I think

As a proponent of index funds, I pride myself in being average. That word usually doesn’t carry great connotations, but in the investing world, it isn’t such a bad thing.

Still, sometimes average isn’t good enough. For investors aiming to outperform the market to achieve their goals, multifactor investing offers a compelling alternative. It doesn’t come with the usual drawbacks of active funds like higher fees and manager risk but takes a rules-based approach to deliver alpha. I believe it’s a good in-between in that it systematically tilts a portfolio towards proven drivers of return while also maintaining the discipline of indexing.

Making the move from broad based ETFs to single-factor or multifactor funds is far from a free lunch. You are essentially betting on historical drivers of returns and potentially watering down the impact of these through a multifactor approach. Moreover, you’re also paying a higher cost for your wager.

I believe that for the average person, investing shouldn’t be complicated. If it requires pouring through a vast heap of academic papers, dedicated to unearthing elusive drivers of alpha under every market condition, I’d rather not. And that’s assuming that the academics reach a consensus (which is rarely the case). I lose no sleep with broad market exposure, low costs and the contentment of achieving the average.

It also doesn’t require a this or that answer. Ultimately, it boils down to your conviction. Everyone’s portfolio inherently carries factor exposure. The question is whether you want to lean into those supposed returns-driving traits or just let them happen by chance.