Strength in numbers

Multi-factor funds prove that being popular is not easy. Lynn Strongin Dodds looks at how to navigate the complex world of next generation smart beta products.

“A top-down approach is not a good way of capturing the factor exposures.”

Chris Mellor, Invesco PowerShares

Smart beta may account for a sliver of total passive assets under management but it is one of the hottest topics in investment circles. It is, therefore, only natural that multi-factor funds are the next stage of the asset class’ evolution. 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 for multi-factor funds 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 (£2.7bn) in assets under management at the end of 2009 to almost $80bn earlier this year with a broad range of products offered by around 25 fund providers. While this is a sizeable sub-sector of the overall $437bn (£317.4bn) smart beta pie, it is still a small slice of the $3.9trn (£2.8trn) equity ETP industry.There are several drivers behind the trend, and 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,” he adds.VALUE, VOLATILITY AND PATIENCEMorningstar’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 under-performance, 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 out-performance though was notably lower for shorter holding periods. By contrast, an equally-weighted portfolio of factors performed as well or better than the best performing single factors over all time horizons.Diversification contributed to an out-performance of the portfolio 80% of the time compared to the S&P 500 over one-year and 97% of the time over three years. Another significant benefit are 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. The share of passive assets has doubled in Europe over the same time horizon, albeit the figure is only at 15%. This is expected to change as the Financial Conduct Authority and MiFID II tighten 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 which 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 out-performance. You do not get any clashes or offsets.”Take value and momentum, which typically have negative correlations. “The momentum strategy might be buying stock X while the value strategy is selling stock X, or at least implicitly in a long only context,” Verhoeven says. “This is just a simple example but clearly shows that while diversification offers huge benefits to investors one has to be smart about implementation. It also demonstrates how returns can be eaten up by turnover providing a clear cut case of the importance of implementation and a good infrastructure to support it.”There is also a growing body of research supporting the bottom up and integrated path approach.The most recent is the 2016 paper: Can the Whole be More Than the Sum of the Parts? Bottom-Up versus Top-Down Multi-factor Portfolio Construction. This analysed the equity factors of value, size, quality, low volatility and momentum to build global portfolios from developed markets.They concur that a bottom-up construction yields superior risk-adjusted returns because the portfolio weight of each security will depend on how well it ranks on multiple factors simultaneously. By contrast, stock-specific risk tends to be more pronounced in the sleeve approach.A separate paper comparing the two, published by AQR Capital Management, found that an integrated approach not only adds about 1% per annum of excess returns versus the cap-weighted benchmark but also increases the level of the information ratios by about 40% relative to the portfolio mix.Trading efficiency is also enhanced, while turnover is reduced by netting trades that would have been executed in separately managed single-style portfolios. Moreover, back tests of the S&P Quality, Value & Momentum Multi-Factor Index showed that a bottom-up approach outperformed a top-down fund of funds as well as each of the individual factors between 1995 and 2017.The index also has the highest average return during each five and 10-year period in the sample horizon, outstripping the top-down approach by an average of 1.6% and 2.4% per annum over each five and 10-year period, respectively.PRIME CHOICEThe other hot topic for discussion is the type of factors that should be slotted into these funds. Unsurprisingly, there are different variations on the multi-factor theme, but, as Verhoeven points out, it is important to note that not every factor is a factor.“A lot of data mining is happening with people trying to come up with a new holy grail or something novel,” he adds. “In this case it is better to be safe than sorry. The ‘standard’ factors have an extensive history in academics and in practice.”AQR Capital Management principal Ronen Israel adds: “You may hear people say that there are hundreds of factors in the market, but, in our opinion, there are in fact only a small number – value, momentum, quality or defensive – that can provide persistent sources of return and, have long-term academic research and economic intuition to support them.“We have, for example, left size out because we do not believe that there is enough empirical evidence and economic intuition to support it as a factor in the way it is traditionally defined and implemented,” he adds.Other key attributes, according to Kalesnik, include robustness across definitions, meaning that small changes in the measurement of a factor should not destroy its demonstrated performance. The same characteristics should be present across geographies to show out-of-sample performance, and finally they should be implementable without incurring large trading costs that erode the factor’s return premium.Looking ahead, more producers are expected to jump on the bandwagon and multi-factor strategies will only become more sophisticated. The recent debut of Amundi’s dynamic multi-factor euro, Europe and global equity range is a case in point. They differ from many in that they place risk management at the heart of the portfolio construction.According to Amundi’s head of ETF product specialists, Nicolas Fragneau, equity factor investing relies on a long-standing research framework which dates back 60 years. In addition to the passive solutions relying on index providers and research from ERI Scientific Beta, Stoxx and MSCI, Amundi Active Multi Factor portfolios are built through the group’s proprietary research.Factors are then combined using a strategic allocation methodology and each factor is equally weighted to the portfolio risk profile. The team also re-adjusts tactically among factors to avoid bias and to tackle valuation risks plus portfolio guidelines are applied to avoid concentration and limit execution costs. The move to a multi-factor approach is understandable, but it does not eradicate risk. So tread carefully when picking your team of factors.