A transparent index methodology should clearly explain index construction. Vague language may imply greater complexity and uncertainty in what is supposed to be a “rules-based” index.

• Can the issuer explain the index methodology enough for you to fully understand it? If not, consider a more straightforward alternative.

Having sufficient history allows you to analyze how the index performed during various market cycles, especially relative to cap-weighted indexes.

• Verify if the index was newly created. If historical data is displayed, investigate whether it is actual versus hypothetical performance.
• If the index was created by the ETF issuer to launch a product, confirm if the index was based on an existing active strategy. If so, make sure you understand any differences.

The ETF issuer should present a clear story and purpose behind the strategy’s usage in a portfolio.

• Determine if the strategic beta ETF can serve as a complement or a replacement to cap-weighted ETFs.
• Understand what, if any, differentiation the strategic beta ETF provides compared to cap-weighted ETFs in terms of size, sector and factor tilts.
• Keep in mind that a fund that looks “inexpensive” may actually be “expensive” if it offers little to no diversification from a low cost cap-weighted ETF.

In the example below using the MSCI Factor Box, you can see the factor diversification obtained in value, momentum, quality, yield and growth, by combining a value-oriented strategic beta ETF (Fund A) with a cap-weighted ETF (Fund B).

For illustrative purposes only.

Checking the ETF’s closure risk is imperative, especially for strategies with lots of competition, such as multi-factor ETFs, which have proliferated in recent years.

• To determine an ETF’s closure risk level:

  • Check if the ETF’s assets and liquidity are sufficient for long-term survival
  • Check the issuer’s history with ETF closures
  • Check the competitive landscape to determine the ETF’s viability in its category

Cost efficiency is an important element in achieving investment goals over time.

• Compare the ETF’s expense ratio to ETFs with similar strategies from the same Morningstar Strategic Beta category, but avoid choosing a fund solely based on fees.
• Look at the ETF constituents’ size and liquidity. Smaller, less liquid stocks may carry disproportionately large portfolio weightings in certain strategies, potentially leading to wider ETF bid/ask spreads and higher costs to transact in block sizes.

Index providers often consider different metrics, or “ingredients” in creating factor-based indexes. For example, various value-tilted indexes may diverge in sector exposures (and performance) based on the metrics employed to create the value tilt.

• Check the index methodology to verify and understand the metrics used to create the factor tilts.

Among multi-factor ETFs, there is great difference in how many and which combination of factors are employed.

• Check how many factors the index is targeting, and make sure the combination of factors employed aligns with your objectives.

Some multi-factor strategies provide equal exposure to each factor. Some overweight/underweight certain factors. And others may periodically shift the factor exposures “dynamically” based on models.

• Understand how much exposure (or weight) is given to each factor in constructing the index.

Multi-factor indexes are constructed using an isolated (top-down) or integrated (bottom-up) approach, which can impact the factor characteristics of the index.

• An isolated approach starts with the creation of several single factor indexes that are usually equal-weighted to create a “master” multi-factor index.
• An integrated approach often measures each constituent based on a number of factors, then selects and weights the constituents based on an aggregated “factor score.”