Is the multi-factor craze the next fool’s gold rush?
In the popular 90s video game Tomb Raider, Angelina Jolie’s alias Lara Croft traversed the world, opening chests and crypts and looking for different but complementary treasures. Multi-factor investing isn’t wildly different, but all that glitters is not gold…
In the course of my own factor-based investing quest, I am often asked if multi-factor investing is inherently contradictory. By definition, any investor who wants to isolate a single factor is deliberately hedging out all other risks, right? And, as different factors have different objectives in a multi-factor portfolio, some of them could contradict each other. Surely putting multiple factors together reintroduces multiple forms of risk and the more types of risk you add, the more your portfolio approaches the broad market risk/return profile?
So, how can you avoid re-introducing market risk into your portfolio and gain the potential to generate returns above the broad market? Below are some gems I’ve gleaned along the way…
Although past returns offer no guide to future performance, based on favourable historical returns multi-factor has delivered a positive difference. The chart below illustrates the sizeable historical performance difference between market returns and multi-factor. Compounding effects have made the return disparity significant over the long term.
That said, the naysayers are not entirely wrong – multi-factor, in this case a blend of the factors identified, has delivered lower returns than the best performing factors, especially the size factor and momentum.
This is because some ‘returns cancellation’ is difficult, or impossible to avoid – value stocks and momentum stocks inherently hold opposing characteristics and may outperform at different points of the market cycle; multi-factor incorporates both. However, it is perilous to confuse multi-factor investing and market-cap investing suffering from similar ‘returns drag’ with multi-factor investing producing the same returns pattern as the broad market.
A commonality in all key factors is that they will move your portfolio away from the ‘tallest trees’ in the index – i.e. the giants that dominate most global benchmarks. So, no matter how many factor strategies you blend, you are likely to be underweight to the largest names in the index. This can translate into a sector – the U.S IT sector contains Google, Facebook, Apple, Amazon and Netflix!
In order to ‘slip’ into replicating market returns, multi-factor portfolio allocations would have to be unbalanced. Below is a chart which shows the factor allocations we would have needed in order to have produced market returns year-on-year. We generated it by assessing the returns of the different factors against market returns, choosing the factor combination which would produce the most similar performance to the market returns in any given year. During volatile years: 2002, 2008 and 2011, an excessive allocation to value stocks would have been needed to match market cap returns, because most stocks within the market cap itself became value stocks after significant corrections.
N.B. There are other combinations which could recreate the market cap returns in some years. This calibration is based on an optimisation – i.e. the most similar match we were able to calculate between factors and market returns.
A balancing act
However, a measured, disciplined and balanced multi-factor portfolio, which equally-weights all factors, should not replicate the market. For example, applying a weighting scheme may help reduce stock specific risk and issuer, stock and regional concentration, likely to lower the portfolio’s beta. This prevents single holdings being represented in the multi-factor portfolio many multiples higher than their market capitalisation.
Furthermore, a close analysis of ‘factor interaction’ might entail the bottom up review of each stock to ensure that its presence supports each of the portfolio’s factors in tandem, rather than a single factor at the expense of others.
So, being disciplined and vigilant in the fight against unrewarded risk is the key to creating a truly original multi-factor portfolio, rather than a broad-market investment in all but name. As the real life Angelina Jolie once said; “People say that you’re going the wrong way when it is simply a way of your own.”