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Can you get low cost outperformance?

Multi-factor funds may provide a compelling offering.

Over the last two decades there has been a massive uptake of index tracking products across the world. According to figures from Deborah Fuhr of ETFGI, there is now more than $4 trillion invested in exchange-traded funds globally.

By far the bulk of this is held in market cap-weighted equity products. These are funds that track broad, ‘vanilla’ market indices like the S&P 500, FTSE 100 or MSCI World.

However, while there is an appreciation for the simplicity and ease of use that these types of products offer, they are not unproblematic. As Erik Christiansen from the EDHED-Risk Institute points out, there are two major criticisms of market cap-weighted indices.

“The first one is a problem of concentration,” he notes. “In South Africa you are very well aware of this problem because it is even worse here than in other markets.”

At the moment, just one stock – Naspers – makes up over 17.0% of the FTSE/JSE All Share Index. The top ten companies together have a weighting of over 50%.

What this means is that even though there may be 160 stocks in the index, you are not truly exposed to all of them. The weightings of the smaller companies are too meagre for them to have any material impact on the index performance.

“Secondly, you also have some unfortunate factor exposures in market cap-weighted indices,” Christiansen notes. “By construction you are overweight large-cap companies, and you are also exposed more heavily to growth stocks.”

That means you are tilted away from smaller value stocks, which, over time, should actually outperform.

Factor investing

These concerns have given rise to new approaches that look to give investors exposure to other market factors. ‘Smart beta’ funds have been developed to focus on things like value, momentum, quality or low volatility.

While these single factor funds have proved popular and can serve a purpose in diversifying a portfolio, they are also not without their problems.

“The temptation has been for factor products to try to maximise factor exposures in the search for returns,” says Christiansen. “But often they forget about the basic principles of portfolio construction, which is diversification and minimising unrewarded risks.”

In other words, single factor funds are often unbalanced. They can, for instance, end up heavily over-weighting specific sectors, which introduces unintended risk into the portfolio.

Many of them also produce irregular performance. While they might outperform over the long term, there can be periods of significant underperformance in between.

“The argument for factors is that you get rewarded in the long term for holding specific risks,” Christiansen explains. “And by definition this means they must be cyclical, because you have to take risk to get a return.”

The danger with this is that it encourages poor investor behaviour. People tend to buy into a single factor or smart beta fund after a period of outperformance, or sell after the fund has underperformed, effectively buying high and selling low.

Multi-factor investing

More recently product providers have been addressing these issues by developing multi-factor funds. Instead of just being exposed to one market risk, such as value, they incorporate a number together to create a more balanced exposure.

“In much the same way as combining different asset classes, each with its own risk/return profile, the returns of many of the established equity factors can be combined in an attempt to diversify the portfolio and provide more stable excess returns,” S&P Dow Jones Indices (SPDJI) notes in a recent paper. “Fortunately, most equity factor returns have low correlations, particularly in times of market stress. Thus, one can logically deduce that using multiple equity factors as building blocks when creating a combined diversified portfolio may allow market participants to increase the frequency of outperformance over shorter time horizons.”

Importantly, the best of these funds also pay a lot of attention to portfolio construction to ensure that they are well diversified and not over-concentrated in any single stock or sector. They therefore also address the issues inherent in market cap-weighted funds.

“What this approach aims to do is look for different sources of outperformance by holding allocations to multiple return drivers,” explains CoreShare’s Chris Rule. “The consistency of returns and the low cost of the packaging is the value add. Without taking timing risks you can substitute a high cost active portion of your portfolio with a solution like this.”

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