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MULTI-FACTOR INVESTING: An overcrowding problem?

Overcrowded_Hong_KongWith multi-factor investing on the rise, Lynn Strongin Dodds looks at the drivers and learns how factors are being combined.

Although multi-factor investing can involve sophisticated quantitative techniques, the main driver behind its increasing popularity is fairly straightforward – the whole tends to be greater than the sum of the parts. This is particularly true over the past couple of years, although investors are advised to examine the construction of these funds closely, as they can differ significantly.

There have been several variations of a theme being launched, with recent figures from BlackRock showing multi-factor assets have grown rapidly from $3.8 billion at the end of 2009 to $70 billion (€60 billion) as of March 2018. In addition, the FTSE Russell report reveals that among global asset owners canvassed this year, multi-factor combination smart beta strategies were used by 49%, a notable rise from 20% when first measured in 2015. Moreover, 87% of those who have implemented a smart beta strategy for the first time within the past two years are using a multi-factor blend.

“Factors which are broad and historically persistent drivers of returns are based on economic foundations and arise through one or a combination of reward for bearing risk, a structural impediment or behavioural biases of investors,” says Manuela Sperandeo, head of iShares EMEA specialist sales at BlackRock. Value, momentum, size and quality have all outperformed the broad market over the long term but because each factor is driven by different phenomena, they tend to outperform at different times. The cyclicality of single factors is unavoidable, therefore diversification is an important benefit of multi-factor investing.”

The classic example is value investing, which had its heyday before the financial crisis but has failed to keep pace or outstrip its growth counterpart. Since the financial crisis bottomed out in March 2009, the broad large-cap S&P 500 has outshone the S&P 500 Value Index by 3 percentage points, while the S&P 500 Growth Index has outperformed value by 7 percentage points in the same period, according to research from FactSet.

“Certain institutions gravitate towards single-factor strategies and one of the benefits is that you have more controls with this approach,” says Dimitris Melas, managing director and global head of core equity research at MSCI. ”However, one of the challenges is that investors have to select the factors and decide how much to allocate to each of them and when to change the allocation. With multi-factor strategies, investors do not have to deal with these decisions. Risk is diversified across multiple factors within the same strategy.”

Institutions also like the fact that the returns come with a lower price tag than active strategies whose fees and performance have been under intensified scrutiny over the past few years.

These solutions are not seen as a substitute for active but more as a complement to the stable of conventional off-the-shelf passive index funds. “The single and multi-factor strategies are now well understood and are available at a more affordable cost,” says Stephan Kessler, lead portfolio manager, alternative investment strategies, Goldman Sachs Asset Management (GSAM).

“We are seeing them being used in two ways: one as an alternative to a direct investment into hedge funds, because they can generate similar returns but offer more transparency and liquidity; and the other is as core investment to diversify away from traditional investments.”

Two choices
Although there are a plethora of funds on the market, construction seems to be based on two principles – the first one being a top-down approach that combines different sleeves of single factors - value, momentum, size, quality, or low volatility or the traditional five. Securities are scored according to each factor; those with higher ratings are given an overweight position while the opposite applies to the lower-rated.

The second structure and one that is gaining traction is the integrated holistic method, which aggregates factor characteristics at the security level.

From a performance perspective, academic literature is split as to its merits. Research from Shaun Fitzgibbons, Jacques Friedman, Lukasz Pomorski and Laura Serban found that integrating styles is a much more effective way to harvest long-only style premia. Compared with the sleeves, it substantially improves both returns and information ratio because it avoids stocks with offsetting style exposures and includes stocks with balanced positive style exposures.

However, a paper published last year by Leippold and Rueegg, which evaluated sets of factor combinations, robust statistical tests and longer time periods, argues that there is no empirical evidence to statistically validate the claim that integrating is superior and produces outperformance. They contend that while it may exhibit a higher sensitivity to the low-risk anomaly, this reduction in risk does not lead to an improvement in returns.

“There is an ongoing debate as to which is the best way to put together a multi-factor portfolio but you have to look at the benefits being gained,” says Ronen Israel, a principal at AQR Capital Management, which favours an integrated approach.

“Mixing together single-factor baskets leads to a portfolio of securities that are strong on a single factor but potentially weak on other factors. In an integrated approach, you select the securities that are strongest in combination across multiple factors, leading to a more effective portfolio. There is also the benefit of lower transaction costs because potentially offsetting trades are not being executed as they would be in separately managed, single-style portfolios that were put together.”

Another advantage, according to Invesco’s senior portfolio manager for quantitative strategies, Georg Elsäesser, is a stronger risk management framework and more optimised portfolio.

“Think about a bull market – a lot of the stocks could be exposed to several factors at once and they could offset each other. We believe it is better to take a holistic view and extract the value of, say, momentum, quality and value from each security.”

Ashley Lester, Schroders’ head of multi-asset research and co-manager of the Global Multi-Factor Equity (GMFE) fund, also sees the integrated approach as a more plausible and efficient way to gain exposures to a diversified set of factors. He notes that investors have to look carefully at whether they are buying an integrated or sleeve fund because portfolio construction and the factors included can differ.

“There are some interesting nuances and broad descriptions can be helpful, but they can hide the details,” he says adding that Schroders incorporates the traditional five (value, momentum, quality, low volatility and size) and scores them based on the fund manager’s proprietary research. “We integrate all the information at the stock level and we choose the best stocks based on our consolidated view,” he adds.

GSAM, on the other hand, looks at the factor world mainly in terms of its drivers, which can be classified as carry, value, momentum and structural themes across the asset class spectrum – equities, fixed income, credit, FX, commodities and volatility. “We think financial markets look at multiple angles to determine the price of an asset and so we use a multi-dimensional approach as well combing the information for a specific asset across multiple signals to determine the actual weighting in the portfolio, leading to higher expected risk-adjusted returns,” says Kessler.

“For example, in equities one can look at book-to-price to capture value and profitability to capture quality aspects of an asset. As for structural, we will focus on certain return patterns and liquidity footprints to complement information on assets based on other return drivers.”

Plato’s philosophy
BNP Paribas also concentrates on four factors – value, low volatility, momentum and quality – and employs robust optimisation techniques. “Our construction mechanism starts with a variety of indicators and ideas, “ says Etienne Vincent, global head of quantitative management at BNP Paribas, who draws parallels between four main recurring sources of outperformance in equity markets and the four cardinal virtues identified by Plato. “For example, value can be seen as a form of justice while momentum can be seen as moderation.”

The philosophy behind this is that value consists of investing in the cheapest shares, representing the Platonic sense of “morally providing to each person what is universally due to him”. The premium placed on the style may be due to the behavioural bias of certain investors, who allow themselves to be dazzled by a company’s talk of growth and neglect the importance of financial data in valuing companies, he adds.

As for momentum, he says it appears to correspond to Plato’s virtue of moderation (or temperance), given that it is a form of humility that consists in acknowledging that “others” may have seen something that we overlooked and that it is therefore worth “doing like everyone else” even without a clear, explicit reason. “The main justification for this style’s outperformance is derived from the observation that when humans make decisions we take time to decide but do not easily change our minds subsequently,” he says.

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