Mamdouh Medhat, senior researcher and vice president at Dimensional Fund Advisors, explains how a multifactor approach to equity investment can add value to an investor’s portfolio and deliver improved returns over the long term.
Factor investing grew in popularity after the Global Financial Crisis, which gave way to the longest bull market on record, with single-factor strategies attracting considerable inflows. However, more recently, they have struggled to deliver market-beating returns.
Mamdouh Medhat, senior researcher at $584bn global asset manager Dimensional Fund Advisors, says factor-based investing remains a much more reliable way of delivering long-term returns than market-cap weighted strategies – but only if it is done correctly.
“At Dimensional, we think of factor investing as a systematic way to design and implement investment strategies to pursue higher expected returns than the market,” says Medhat. “It’s a rules-based approach that takes some of the emotion out of investment and replaces it with rigorous research and efficient implementation.”
While many investors often choose a passive or active investment style, a systematic factor-based investment approach offers the potential for market-beating performance without manager-specific risks.
He explains: “There are two competing alternatives to systematic investing. First, traditional active stock or bond picking, where you are relying on the fund manager being able to outperform the market. Second, passive investing, where the goal is not higher returns than the index but to minimise tracking error”.
“What systematic investing tries to do is sit between those two extremes and outperform the market or an index in a rules-based way. Instead of basing investment decisions on a prediction about the future, systematic investors follow research and evidence.”
An approach rooted in academiaAlthough factor investing has become more mainstream in recent years, it is important to note that it is a style of investing rooted in academia and backed by extensive research.
“A factor is a purely academic construction that you can’t invest in directly,” says Medhat. “This is important because it is a long way from thinking about a factor in an abstract academic sense and using it to invest.”
Investment factor models started emerging in the 1970s and 1980s, with the first – the Capital Asset Pricing Model (CAPM) – explaining why stocks that moved with the market outperformed those that did not.
“After that, academics started to identify other factors such as size, which the CAPM model did not explain,” says Medhat, as academics found that the smaller the company, the higher the expected returns.
“In the early 1980s, when this research around the size factor came out, Dimensional founder and executive chairman David Booth wanted to bring it to the market, and that is essentially where the idea of systematic investing started,” he explains.
That early factor research inspired the launch of the world’s first micro-cap strategy in 1981, and it is still running today. Further research in the decades since, notably by Dimensional directors Gene Fama and Ken French, has identified value, profitability, and asset growth as valuable factors.
“More than 450 factors have been proposed since the 1980s, but many are simply too far away from anything you could implement in the market.”
Ignoring the noiseWith so many different factors, there is a wide range of opinions about how to construct a systematic investment approach.
“It might be tempting to jump on the next new factor and try to build investments or portfolios around that because ‘new’ is exciting,” says Medhat. “But if it is not founded in something rigorous, there is no reason to expect it to outperform going forward.”
In the past, investors have poured money into the latest factor in search of returns. An example is low volatility, which delivers market-like returns with a much less bumpy ride, according to Medhat.
“What the research shows is that the low-volatility segment of the market is essentially just a repackaging of things we already know,” says Medhat. “They tend to be relatively large, relatively profitable companies and are more value-like with lower relative prices.”
“There are two competing alternatives to systematic investing. First, traditional active stock or bond picking (...). Second, passive investing."
“While such strategies are appealing in more volatile conditions, non-complementary factors can introduce ‘noise’ into a systematic, rules-based approach,” he notes.
Diversifying across factors that complement each other can reduce volatility. Value and profitability, for instance, are excellent complements because they tend to target different market segments and have, therefore, rarely been negative together.
“Multifactor investing is like having different ingredients, some sweet and salty, or sour and umami,” says Medhat. “Putting them together may give you a much better experience than just having each one by itself.”
Remaining disciplinedOne of the challenges of a systematic factor-based approach is remaining disciplined, particularly when markets become more volatile. Changing your investment approach by adding different types of stocks when market conditions change can harm investors’ portfolios.
“If you believe in a factor, then you should stay invested in it, even during periods when it is volatile. Otherwise, you may miss out,” says Medhat.
“A lot of so-called value funds ended up being growth funds in disguise during the decade where the value premium was not as impressive as its historical average. And that lack of discipline meant they ended up underperforming when the premium rebounded more recently.”
However, investors may want to invest with a consistent portfolio manager and a firm that understands the importance of remaining disciplined when markets are more volatile.
“One thing that we strongly believe in is diversification,” adds Medhat. “It has been called the only free lunch in finance, and it helps capture premiums because we do not know which securities will deliver on any given day.”
Ultimately, investors must judge whether their managers are delivering what they promised, which is easier with a systematic approach.
“Any manager can look phenomenal if they are lucky and manage to pick the right stocks or hit the market at the right point in time,” he says. “And they can also look bad if they are unlucky.”
“While the performance itself is an important aspect of judging a manager, investors should focus on consistency of performance as that is a sign that a manager is following a process; a lack of consistency could reveal inefficiencies or the lack of a well-defined approach,” says Medhat.
“You need to judge a manager holistically, from their research to the design and management of their portfolios,” says Medhat. “Are they doing everything they can to maximise performance and minimise risk?
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