ETF Expert Corner

Global X’s Jay Jacobs Talks Multifactor Investing, Smart Beta ETFs

April 26th, 2016 by ETF Store Staff

Jay Jacobs, Director of Research at Global X, discusses multifactor ETFs, including spotlighting Global X’s lineup of Scientific Beta ETFs.



Transcript

You can listen to our interview with Jay Jacobs by using the above media player or enjoy a full transcription of the interview below.

Nate Geraci: I'm now pleased to welcome to the program Jay Jacobs, Director of Research at Global X. If you're not familiar with Global X, they're a leading developer of very innovative ETF solutions. They currently offer nearly fifty ETFs with over three billion dollars invested in those ETFs. These include everything from global dividend focused ETFs to China sector ETFs to ETFs covering the MLP space. As I mentioned earlier, Global X does offer a suite of multi-factor ETFs, which is what we'll be focusing on today. Jay Jacobs is joining us via phone from New York. Jay, a pleasure to have you on the program today.

Jay Jacobs: Thank you. It's a pleasure to be here.

Nate Geraci: Well Jay, Conor and I tried to set the table for you a little bit in our first segment. We talked very high level about smart beta ETFs, how they select and weight holdings based on different factors, something other than just market cap. To start here today, can you maybe describe to our listeners what a factor is, and perhaps touch on some of the more popular factors out there?

Jay Jacobs: Very broadly speaking, a factor is a characteristic that helps explain a group of stock’s risks and returns. If you think about it, the first factor that really came out was called the market factor, which is more commonly considered sort of beta, stocks beta. A stock with a high beta is considered more sensitive to the market. If the market is rising, that's a good factor to have. It should outperform. If the market is falling, it's a bad factor, and you could underperform. What really changed in the factor space was when Fama and French came out and said, there's actually more factors than just market beta. There's size, how big a company is. There's value, how cheap a company is. They can help explain really the risks and returns of those stocks. Not only can you explain how they perform using those factors, but you can actually see which factors are better rewarded over the long term. They showed that value tends to outperform growth over the long term. Small size tends to outperform large size over the long term. This really opened the door for other academics to come in and say, "Hey, there's actually other factors." Low volatility is one; momentum is another. Suddenly, we started having multiple factors that could be used to help explain how stocks perform, and to see which ones really can outperform over the long term.

Nate Geraci: Jay, what makes for a good factor? Because there are literally hundreds of factors out there, where some academic will tell you the factor is capable of beating the market. What distinguishes a good factor around which to build an investment strategy?

Jay Jacobs: That's a great question. A good factor is a robust one. One that will work over the long term as you expect it to. The way you can test for this is to look across different time frames, across different geographies, even different asset classes to see if the factor behaves as you would expect. If it does work in different decades, different regions, different asset classes, that's probably a robust factor. The problem is we have so much computing power these days that a lot of people will go factor fishing, which is looking for a factor that might not be there. You do want those factors that are robust and have academic consensus.

Nate Geraci: Many of the smart beta ETFs currently on the market are focused on a single factor, whether it be value, momentum, low volatility, some of the other ones that you mentioned, but Global X offers a suite of ETFs that use multiple factors. You call them Scientific Beta ETFs. What are some of the benefits of using a multi-factor approach verses a single factor approach?

Jay Jacobs: Just as we said that some factors tend to outperform over the long term, they can still go through periods of underperformance that can extend for multiple years. We just saw that the value factor has underperformed for multiple year periods. If you were just invested in the value factor, that would not be good for your portfolio. Using multiple factors at once seeks to diversify those exposures. Even if value is underperforming, another factor like low volatility is doing very well. Just like you would diversify individual stocks, diversifying across factors can help smooth out the ride.

Nate Geraci: You mention diversification, which obviously is a good thing. I guess just playing devil's advocate. I might be concerned that if you combine multiple factors, you can end up with performance and risk characteristics pretty much in line with a traditional low cost market cap weighted index fund. How do you avoid this when you're combining multiple factors?

Jay Jacobs: It really comes down to the construction of the index methodology. You're right in saying that if you look at a multi-factor index, it will hold many stocks. Our Scientific Beta U.S. Fund owns 480 of the 500 stocks in the S&P 500. What it comes down to is how those stocks are weighted. If you look at the active share, which is essentially the difference between our portfolio and the S&P 500. There's only a 50% overlap by weight. Even though we're owning many of the same stocks, we're tilting towards those stocks that have better value characteristics, better momentum characteristics. You will see over time that that is the difference between a cap weighted portfolio and one that is trying to get factor exposure.

Nate Geraci: We're visiting with Jay Jacobs, Director of Research at Global X. Jay, let's talk a little bit more about the Global X suite of multi-factor ETFs. They are called Scientific Beta ETFs. There are four ETFs covering the US, Europe, Asia ex Japan, and then Japan. Can you tell us more about these ETFs, maybe the factors used and just high level how they're constructed?

Jay Jacobs: Sure, absolutely. Each of these funds are constructed in a very similar manner. The only difference is the region they're trying to get exposure to. They are accessing four factors at once: the value factor, the size factor, low volatility, and momentum. These are factors that have very broad academic consensus out there for being robust factors. The way they're constructed is really a very template approach, where it's creating four separate indexes, each targeting one factor at a time, and then combining those four indexes together for the multi-factor approach. I know that can sound a little complicated, but really what it's trying to do is use a very standardized approach to accessing all the factors, and then get that diversified multi-factor approach at the end.

Nate Geraci: Jay, just boiling it down, if you were to compare perhaps your U.S. Scientific Beta ETF to a standard S&P 500 ETF, how should I expect that to perform? What are the general risk return characteristics of the Scientific Beta ETF?

Jay Jacobs: As I mentioned, we're owning 480 of the 500 stocks in the S&P 500. It's a very broad approach. There isn't a ton of tracking error between the S&P 500 and our portfolio. You will see in some periods multiple factors will not work. There could be periods of underperformance and other periods factors are working, and you will see factors of outperformance. In general because we're talking such a broad approach, it really can be used as a core holding that will perform as you would expect a large cap fund to perform.

Conor Kelly: Jay, this is Conor Kelly. A quick follow-up on this. With the four factors you guys are using, is it static between the four? Based on factors performing well or performing poorly, do you guys tactically change the weight in each of those four factors within these ETFs?

Jay Jacobs: That's a great question. On a quarterly basis, the weights across those four factors can change. What we're trying to do is tilt towards the factors that have the least tracking error to the S&P 500. Basically, if we're in a value market, we're going to tilt more toward the value factor. This should reduce the overall tracking error of the strategies, so we'll perform more like a cap weighted benchmark like the S&P 500.

Nate Geraci: Jay, for listeners out there, why should investors consider multi-factor strategies? You mentioned that these particular ETFs, they may serve as nice core holdings, but why consider multi-factor strategies?

Jay Jacobs: It's really for investors that are looking for outperformance over the long term. We're in an environment right now where GDP growth is slowing across developed nations. We're in a very mature state for many industries. Growth is something that's hard to come by. Outperformance is one way of trying to achieve growth that might not necessarily come there from just owning a cap weighted benchmark over the next decade.

Nate Geraci: Again, we're visiting with Jay Jacobs, Director of Research at Global X. Jay, as it relates to performance, we've all see studies showing where smart beta strategies will have unbelievable back tested performance, but once they go live, the performance isn't always there. Is there a concern that once these strategies are packaged up and brought to the mass market they no longer work? Either there is data mining involved in the back testing or that the advantage simply gets arbitraged away once these products are available to everyone. I'm just curious, what are your thoughts on that?

Jay Jacobs: That's a great question. It comes back to the robustness of the factor. If it's a true robust factor, it should work over the long term. This is where people get in trouble though because they have so much computing power that they can look back and try to refine factors or find a new factor that may not truly be robust. When they package that up and put it in an ETF, suddenly, hey, it stops working. If it were a robust factor, that wouldn't be the case.

Nate Geraci: I think that's a great point. With all the smart beta ETFs available to investors, whether we're talking single factor ETFs or multi-factor strategies, there are a lot of ETFs for the average investor to digest. What do you think are some of the key things investors should look at before deciding to invest in a smart beta ETF?

Jay Jacobs: Investors really need to do their homework. There's obviously many products out there. One of the things investors should do is look at the methodology for the product. If you just look at the top level marketing, you'll see a lot of the same factors are out there, a lot of the same marketing words, such as outperformance or lower risk. You really have to dig in and see what factors are they accessing, how are they defining those factors, and how are they combining them at the end of the day.

Nate Geraci: Jay, we always advise people that if you're going to use smart beta ETFs, such as your multi-factor ETFs, it's important to let them work over time. In other words, if you think about something like value or momentum, those factors aren't going to outperform every single year. There will be ups and downs along the way, and the potential for outperformance comes over a much longer period of time. Do you agree with that approach?

Jay Jacobs: Yeah, that's exactly right. A long term approach definitely makes sense for factor investing. One of the reasons why these factors are rewarded is because many investors don't have the patience to invest in them. If it was a short term consistent outperformance every day that you can count on, that would be arbitraged away. The fact that it takes many years for value to express itself, and it can go through various up and downs, is exactly why it's a rewarded factor.

Conor Kelly: Jay, it's Conor again. How did you guys settle on all four factors? My question is if this is a long term approach, what did your guys' research show? Was it better to just simply have exposure to one of these robust factors like momentum, like low volatility? Do you achieve superior outperformance over the long term, but with higher risk, higher volatility in the short term? Explain why you guys settled on using all four.

Jay Jacobs: We partnered with the EDHEC Risk Institute, which is a business school out of France. They've really done a lot of research in this space as to what factors are robust and how it makes sense to combine them. If you just invested in the value factor, and held onto it for forty years, sure you could have great performance, but with greater risk. By combining these four factors, it's really trying to get at risk adjusted returns. By holding these four factors, we're limiting the underperformance that can persist for a few years, and trying to diversify across different factors.

Nate Geraci: Jay, we have just a few minutes left here. Before we let you go, I have to ask you about a new ETF Global X launched last week, the Global X S&P 500 Catholic Values ETF. The ticker on that is CATH, great ticker. This is a so called socially conscious ETF, perhaps the exact opposite of the SIN indexes that are out there. Can you tell us about this ETF and perhaps why Global X decided to launch it?

Jay Jacobs: We've seen a lot of popularity recently in SRI investing or values based investing, where investors want to put their money behind an idea rather than just an asset class. Investing can be very impersonal to many people. You're just trying to make money off of money. If you can put it behind something that matters to you, then you can get some sort of additional utility out of that investment. This was actually specifically a strategy that came to us from a client, who was trying to do Catholic investing on an individual stock bubble, and found that it would be more cost efficient, more tax efficient to wrap it up into an ETF. So he worked with us and S&P Dow Jones to create an index that would really achieve their goal of Catholic Values based investing in the cost effective, tax efficient wrapper of an ETF.

Nate Geraci: Do you think we'll see more of these types of ETF products being launched over the next several years just in the social conscious arena?

Jay Jacobs: Absolutely. In the institutional space, there are trillions of dollars investing in SRI, values based investing. In the ETF world, it's still relatively small, so I believe they'll be many more products and more assets coming to this space.

Nate Geraci: Jay, we'll have to leave it there. Fantastic discussion today. Smart beta, this is a fast growing segment of ETFs, we certainly appreciate your insights. There's a lot for investors to walk through and understand in this space. We certainly appreciate you joining us today. Thank you.

Jay Jacobs: Absolutely, thank you.

Nate Geraci: That was Jay Jacobs, Director of Research at Global X. You can learn all about the Global X lineup of ETFs by visiting globalxfunds.com. That's globalxfunds.com.