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The multi-factor fund approach

Multi-factor strategies build upon the concept of diversification: that combining exposures to factors can help soften the effect of drawdowns and increase the potential for outperformance.

Over the years the techniques and strategies used to manage capital in portfolios have shifted. We have seen a move from using investment styles defined as a ‘style’ to which a fund manager would naturally gravitate towards, based on their personality or the way they perceive the market. This could be seen in the way that Warren Buffet manages capital on behalf of the investors who invest in his fund. Buffet is often referred to as a ‘value’ investor in that when he purchases a share, his principle belief is that the share is undervalued, and he will then hold that share for an extended period (In his case a very extended period).

These ‘styles’ have since evolved into a multi-manager approach where fund managers would team up to complement each other’s styles all working for the same portfolio (many times the fund is under a third party name).

In recent years we have seen the ‘passively-managed fund’ where there is no real fund manager – a digital system is used to track an index. This is very common in the exchange-traded fund space.

More recently we have seen further development in these techniques and strategies in that investment ‘factors’ have been identified and these are then used to design algorithms to manage a portfolio’s assets.

This article discusses the next step in the development of investment management techniques, the multi-factor fund approach.

While passive smart-indexing investing or ‘smart beta’ investing is often treated as a new investment trend, the truth is the idea of weighting equity benchmarks by methodologies other than market capitalisation has been around for several decades. For example, equal-weight and weighting stocks by value or growth traits are not new ideas.

However, there are new concepts in the world of smart beta, including multi-factor funds. Smart beta investing has been a significant growth engine for the broader passive management unit trust and exchange traded funds (ETFs) industry, and within the smart beta industry, multi-factor funds are proving to be an important addition.

Multi-factor funds offer investors simultaneous exposure to more than one investment factor. Multi-factor funds improve investor return profiles by addressing the risks inherent to single-factor smart beta funds.

From year-to-year, different individual investment factors shine while others lag. For example, while the value is often a winner over the long-term, value stocks can underperform growth and momentum equivalents for many years in a row.

Multi-factor funds benefit from diversification, which Nobel Memorial Prize-winning economist Harry Markowitz has described as the only ‘free lunch’ in investing. Investors shouldn’t put all their ‘eggs’ in one factor.

Using data from Salient Quantitative Investment Management, we studied the performance of four factors (value, momentum, business quality and low volatility) over the past 15 years from 2003 to 2018. Over this time period, each of these indexes has outperformed its market-cap-weighted parent. Furthermore, all but one of them also produced superior risk-adjusted returns, as measured by Sharpe ratio. Are these factors a ‘free lunch’? Hardly.

Source: Salient Quantitative Investment Management

What the performance graph doesn’t adequately show is the cyclicality of these factors’ performance. While each of the factors delivered better absolute and risk-adjusted performance relative to the market, it was not all smooth sailing. This is apparent below, which is a “quilt” of these factor indexes’ calendar-year returns over the past 15 years.


Source: Salient Quantitative Investment Management

Each of these factors has and will continue to experience its own unique cycles. Stretches of market-beating performance are invariably be followed by prolonged underperformance.

More than just the cyclicality of the performance, is the magnitude of how much the performance of each factor strays from the market. The further, on average, the performance of each factor falls below the market, the more distress an investor may feel, often leading them to disinvest from the factor strategies at precisely the wrong time before the factor strategy begins to perform again.

Owning a proven factor on a stand-alone basis has the potential to deliver better risk-adjusted returns relative to owning the market, but it is hardly a free lunch. Bouts of underperformance can lead to buyer’s remorse, which in turn can create the risk of bad investor behaviour.

To benefit from the potential rewards of factor investing, combining factors into one strategy may produce more consistent results than investing in single factors. Multi-factor funds combine single-factor strategies to create a portfolio with multiple factor exposures. These multifactor strategies build upon the long-standing concept of diversification: that combining exposures to factors can help soften the effect of drawdowns and increase the potential for outperformance.

Below is a correlation matrix that shows the correlations of the excess returns among the factors. It is apparent that some factors, measured in terms of their historical correlations, complement each other very well. when one factor underperforms, the other tends to outperform. Combining funds with low correlations reaps all the benefits of diversification.


Source: A-Dex Prism


By plotting all the possible portfolios of combinations of the different factors, we get a graph showing the trade-off between the risk and return of all the possible combinations of portfolios.

Source: A-Dex Prism


This graph, of which the top left edge is called the “The efficient frontier” allows investors to choose a combination of factors that has either the highest expected return for a defined level of risk or the lowest risk for a given level of expected return.

The right side of the efficient frontier includes combinations of factors that are expected to have a high degree of risk coupled with high potential returns, suitable for highly risk-tolerant investors. Conversely, combinations that lie on the left side of the efficient frontier would be suitable for risk-averse investors.

Various multi-factor portfolios of different combinations can thus be created with superior risk and return characteristics than any of the single factors on their own, moreover the risk profile can be tailored to the investors specific risk requirements.

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Michael Haldane

Global & Local The Investment Experts


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