By contrast, an equally-weighted portfolio of factors performed as well or better than the best performing single factors over all time horizons. In number terms, diversification contributed to an outperformance of the portfolio 80% of the time compared to the S&P 500 over one-year and 97% over three years.
Another significant benefit is lower transaction costs, believes Vitali Kalesnik, head of equity research at Research Affiliates. “They are typically not top of the list for an investor but they should be.
“A diversified multi-factor strategy can substantially reduce transaction costs compared to single factor strategies,” he adds. “Based on our estimates, the costs associated with constructing a multi-factor portfolio is in the order of 15bps to 30bps on an annual basis while it can run as high as 150bps to 200bps for a single strategy.”
More generally, multi-factor investing is part of the overall migration towards passive from active investing.
Figures from Morningstar show that slightly more than a third of all assets in the US are in passive funds, up from about a fifth a decade ago. This has doubled in Europe over the same time horizon, albeit the figure is only 15%. This is expected to change as the UK’s Financial Conduct Authority and MiFID II tightens the screws on fund management fees.
Up or down?
As Stan Verhoeven, NN Investment Partners’ portfolio manager factor investing & solutions, puts it: there is recognition that many things previously labelled ‘alpha’, which came with a higher price tag, are actually factors which have a long history in academics and in practice.
“These factors can be captured systematically, at relatively low costs and have been proven to offer benefits in terms of diversification and attractive returns,” he says.
“The awareness is also a result of increased transparency which enables clients to have better insights into what they are holding in their portfolios and as a result create better portfolios themselves.”
The challenge is, of course, finding the right mix of factors. “Multi-factor investing makes sense but the devil is always in the detail,” says Vincent Denoiseux, head of quantitative strategy at Deutsche Asset Management.
“They are more complex products and there is no one right way to build a product. It is important though that it delivers performance, investors understand the methodology and that the process is transparent.”
In essence, there are two schools of thought on how best to build such a product. The first being a top-down approach, which combines distinct sleeves for each factor often in an equally weighted manner.
It draws on the differentiated sources of return in a relatively simple and transparent way and but can also lead to a dilution of portfolio-level factor exposures. The second option – a bottom-up approach involves an integrated structure where individual factors are combined and each stock rated to create a multi-factor score.
This is then used to select a more concentrated portfolio of so called “all-rounders” that are characterised by exposures that are fairly evenly distributed across all the desired return drivers. While there are debates as to which one is better, the bottom-up contingency is gaining traction.
“A top-down approach is not a good way of capturing the factor exposures,” says Chris Mellor, a product specialist at Invesco PowerShares.
“A bottom-up approach provides minimum exposure to unrewarded sectors and countries and maximum exposure to long-term factors that drive outperformance. You do not get any clashes or offsets.”
