A Compelling Multifactor ETF

There’s a lot to like about Vanguard U.S. Multifactor ETF (VFMF). (Full disclosure: I own this fund.) It targets stocks with the best combination of value, momentum, and quality characteristics. Each of these characteristics has historically been linked to market-beating performance, but they each go through extended periods of underperformance. Combining these factor strategies in a single portfolio helps diversify risk, making it easier to stick around long enough to benefit from these bets.

There are many multifactor funds on the market, but this fund stands out because it covers the full U.S. market-cap spectrum, while most of its peers focus on large-cap stocks. That not only improves diversification, but it should also help improve performance, as the payoff to factor investing has historically been greater among smaller stocks.

Second, while this strategy is rules-driven, it doesn’t track an index, so the managers have some flexibility around when they rebalance the portfolio and may avoid trades where the cost exceeds the expected benefit (similar to how DFA and AQR think about implementation). That should help reduce transaction costs and increase capacity, though capacity shouldn’t be an issue for a long time, as this fund is tiny.

Third, this fund’s approach to portfolio construction is transparent, but it doesn’t simply combine separate individual factor portfolios. Rather, it achieves stronger factor tilts by targeting stocks with the most potent combination of factor characteristics.

This strategy should offer higher returns than the Russell 3000 and Russell Midcap indexes over the long term. While it falls in the mid-cap blend Morningstar Category, it could serve as a core holding or even as a replacement for a large-cap index fund. 

Strategy Overview

The fund starts with the stocks in the Russell 3000 Index. It then filters out some of the least liquid stocks from that universe. The managers divide the universe into three size buckets: large-cap, which includes the largest 200 stocks; mid-cap, which includes the next largest 800 stocks; and small-cap, which covers everything else. The most volatile 20% of stocks (by count) in each of the three size buckets are thrown out because they tend to have less stable factor characteristics. And historically these stocks have tended to offer poor compensation for their risk.

Vanguard sorts the remaining stocks in each bucket using a simple average of their value, momentum, and quality scores and targets those representing the best scoring third by market value. Finally, it weights its holdings within each size bucket by the strength of their factor characteristics, so it tends to cover less than a third of the market. The portfolio is roughly evenly split among the large-, mid-, and small-cap holdings.

The metrics behind the three factor scores aren’t special. Vanguard assesses value based on price relative to book value, forward earnings, and cash flow. The momentum score is based on total returns over the past seven and 12 months (excluding the most recent one) and risk-adjusted returns over the past 12 months. Return on equity, gross profitability, and balance-sheet strength determine the quality score.

This approach is laudably simple and transparent, but it would be better if the strategy made sector adjustments to the value and quality scores to facilitate cleaner comparisons and reduce structural sector tilts. Historically, value-driven sector tilts haven’t been well rewarded, as most of the return benefit appears to come from stock selection. That said, this strategy should still be effective.

Because it uses a composite factor score to select its holdings, this fund won’t necessarily own the cheapest stocks, or the stocks with the best momentum, but rather it will own those with the best overall combination of characteristics. This should lead to slightly more potent factor exposure at the portfolio level than an investor could achieve by combining Vanguard’s individual factor exchange-traded funds because there isn’t much overlap among their holdings, which can dilute the combined portfolio’s factor exposures.


While this portfolio holds less than a third of the stocks in the Russell 3000 Index, it tends to be less concentrated. The top 10 holdings currently represent less than 10% of the portfolio. The fund has some large sector tilts relative to the Russell 3000 Index, as it doesn’t make any sector-relative adjustments in its stock selection criteria or limit its sector weightings. It currently gives overweightings to consumer cyclical and industrial stocks, and underweightings to the technology, healthcare, and real estate sectors. That said, the portfolio is still fairly well diversified across sectors. The composition of the portfolio can change considerably overtime, largely because of its factor signal weighting approach and inclusion of momentum. In the most recent fiscal year, the portfolio’s turnover was 64%.

This portfolio sits squarely in mid-blend territory, owing to its equal allocations to large-, mid-, and small-cap stocks. That alone can drive big performance differences between this portfolio and its starting universe, the Russell 3000 Index.

The fund has gotten off to a slow start, lagging the Russell 3000 Index by 6.8 percentage points annually from its inception in February 2018 through July 2019, largely because of its industry and value tilts. That’s certainly disappointing, but it isn’t worth reading too much into this short record, as there is a lot of noise over short intervals. Even the best strategies can underperform over several years.


Bronze-rated iShares Edge MSCI Multifactor USA ETF (LRGF) (0.20% expense ratio) is a close alternative. This strategy uses a more complex optimizer to maximize the portfolio’s exposure to target large- and mid-cap U.S. stocks with the most attractive combination of value, momentum, quality, and smaller size characteristics. While this tends to have a slightly higher active share than VFMF, it has exhibited lower tracking error to the market, and it limits its sector tilts relative to the market.

Bronze-rated Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF (GSLC) (0.09% expense ratio) offers more-modest factor tilts than LRGF and VFMF. It combines four separate factor sleeves, that each target large-cap stocks with a different factor of interest: value, momentum, quality, and low volatility.