Why multi-factor ETFs make sense

Simon Brown, founder and director of JustOneLap.com.
Simon Brown, founder and director of JustOneLap.com.

CoreShares wants to change the mandate of its equal-weighted Top40 Exchange Traded Fund (ETF), CSEW40*.

Now, before they can change anything, they need the approval of current holders of the ETF, so we all get to vote. You get one vote per ETF and they require a 25% ‘turnout’ and a simple majority will win the day. If you hold this ETF, contact your service provider and ask them about the process of voting – you have until the end of March.

The reasons for the change are twofold. Firstly, the ETF has had a torrid time and the market cap has fallen from over R400m some six years ago to a current R120m. This makes for a small and uneconomical ETF. There are certainly smaller ETFs on the JSE by market cap, but CoreShares is a small ETF house, so it really needs profitable ETFs.

The main reason for the proposed change is that equal weight is a single factor when investing. The other factors are: low volatility, value, momentum and quality, bringing it to a total of five factors. The CoreShares logic is that holding only one factor means you can have prolonged periods of underperformance relative to the index. This is what we’ve seen with CSEW40, as it has underperformed the Top40 over the last one, three, five and ten years. The research tells us not to worry – typically with a single factor you’ll have a short, wild period of massive outperformance that will balance everything out and leave the holder ahead. But while waiting, far too many investors rather vote with their wallets and exit – and the fall in market cap tells us this is exactly what’s happened.

The new proposed ETF (it will list in May if the vote gives them the go-ahead) will have the JSE code SMART and will be multi-factor. It will weight stocks across the five factors mentioned above. The universe of stocks currently consists of the 52 largest stocks on the JSE, and the stocks will be run against each factor; the weighting per factor will be determined before adding the five factor weightings together for a final weighting.

Importantly, the stocks will be capped at three times the equal weight of each stock. With 52 stocks the equal weight is 1.9%, so the cap is 5.7%. This can change as the number of stocks can also change, and 52 is at the low end of the range in the back-testing.

The reason for multi-factor is to get away from long periods when one factor is winning and others losing. As investors, we can try to pick the winning factor but frankly that’s unlikely to work consistently – so the next best option is to then just own all the factors in one basket.

Many have suggested to me that CoreShares should rather just keep the CSEW40 and list a new multi-factor ETF, and this is a totally fair comment. But I suspect that they’d then close down the CSEW40 due to the costs of running such a small ETF.

Personally, holding the CSEW40 was about having 40 out of 40 stocks that drive returns, which is exactly what equal weighting does. In a vanilla Top40 ETF only the 12 largest stocks drive returns. In this new proposed ETF, 41 out of 52 stocks are driving the return, so we get a wide, diverse ETF and that’s what I want.

I will vote in favour of the change and will continue to hold the new ETF as long as the number of stocks driving returns remains around 80%.

*The writer owns CSEW40.

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