Multi-factor funds prove that being popular is not easy. Lynn Strongin Dodds looks at how to navigate the complex world of the next generation of smart beta products.
“Multi-factor investing makes sense but the devil is always in the detail.”
Vincent Denoiseux, Deutsche Asset Management
Smart beta may account for a sliver of total passive assets under management but it has become one of the hottest topics in investment circles. It is only natural that the next stage of evolution would be multifactor funds. As with any diversification strategy, they aim to ease the investment journey, although combining factors is a more complicated task. Careful attention also needs to be paid to construction and methodology.
Demand has been strong in the equity exchange-traded product (ETP) space. Figures from Blackrock show that multi-factor investing has grown from a paltry $3.8bn in assets under management at the end of 2009 to almost $80bn with a broad range of products offered by around 25 fund providers. While this is a sizeable sub-sector of the overall $437bn smart beta pie, it is still a small slice of the $3.9trn equity ETP industry.
There are several drivers behind the trend, although disappointment with some of the individual factors is, most notably, near the top of the list.
Value has had a protracted period of poor returns culminating in Goldman Sachs almost sounding the death knell last year. It estimated that the Fama-French model of buying low-priced stocks generated a cumulative loss of 15% in the past decade compared to the S&P 500, which rose by two-thirds during the same period.
The rout started after the financial crisis and has consistently worsened as tech companies have soared. Last year, for example, they comprised 38.7% of the Russell 1000 Growth Index’s market value, but only accounted for 8.6% of the Russell 1000 Value Index.
“What we have seen is that the large technology companies, the so-called FAANGs (Facebook, Apple, Amazon, Netflix and Google), have dominated the US stock market in the last few years and that has had a significant impact on investment strategies, including single factors,” says Dimitris Melas, MSCI managing director and global head of core equity research. “These risks can be mitigated by diversifying portfolios across several factors which is why we are seeing greater interest in multi-factor funds.”
Value, volatility and patience
Morningstar’s director of passive fund research in Europe, Hortense Bioy, believes that multi-factor strategies are becoming popular because they try to address the shortcomings and cyclicality of the single factor experience.
“Single factors such as value, minimum volatility or quality are cyclical and will go through periods of underperformance although over the long term they should deliver superior risk-adjusted returns,” she says. “This requires patience, which many investors do not always have. So investing in multi-factor products will not only help smooth the cyclicality but also better manage behaviour risk.”
A study conducted by S&P Dow Jones Indices showed that value as well as momentum, low volatility and quality based on the S&P 500 often missed the mark of the underlying index over most time horizons during 1995 and 2017. The frequency of risk-adjusted outperformance though was notably lower for shorter holding periods.
