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 Multifactor Portfolio Construction, which 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 choice
The 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, the product bandwagon is expected to continue 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 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.
