Understanding Multi-Factor Strategies
What are factors?
A “factor” is a generic label for company and stock price characteristics that explain return differences across a broad universe of equity securities. For example, the value factor refers to the tendency of stocks that are inexpensive to outperform more expensive stocks, while the momentum factor denotes the tendency for stocks that have had recent price acceleration to continue that trend for a period of time. Investors are increasingly interested in factor investing due to the potential for more consistent excess returns in relatively cost-effective solutions. **
While there are numerous factors and factor strategies available, there are a relatively small number of factors that are considered robust in seeking to generate a consistent, long-term return premium. ** The criteria often used to determine if a set of characteristics constitute a potentially reliable factor include:
- The factor has a credible and intuitive economic rationale for offering a return premium
- The factor is grounded in rigorous academic literature and backed by empirical research
- The factor is robust across different definitions
- The factor is persistent through time and pervasive across geographies
Research has identified five factors associated with higher returns than the market, as defined below.
- Value and momentum seek to capture the predictability of stock prices – with long-term mean reversion following the dissipation of short-term momentum effects.
- Quality measures the health of the business underlying the stock.
- An allocation to low volatility seeks to capitalize on investors’ preference for high-volatility securities, which drives expected returns down relative to less volatile stocks.
- Size comes into play because these factors tend to be more effective in segments of the market with smaller, less efficiently priced stocks – so a factor may provide higher returns within the small companies universe.
Figure 1:
To take advantage of the potential benefits of factors, many investors turn to smart beta, which is a label for transparent, relatively low-cost and systematic investment approaches. Smart beta strategies are long-only portfolios that are relatively easy and inexpensive to invest in, and commonly are offered in exchange-traded funds (ETFs).
What are single-factor strategies?
As their name suggests, single-factor strategies provide investors with exposure to one factor, such as value, low volatility or momentum. The attraction of single-factor strategies is that they may help investors pursue a specific outcome or range of outcomes, such as improving returns, generating income, or reducing risk.
While single-factor strategies have their benefits, there are also risks associated with these approaches. Many investors want smart beta and factor exposure but are confused by the variety of strategies available in the marketplace. As such, to select a factor portfolio, investors often screen strategies based on past performance. However, selecting recently outperforming strategies can result in favoring strategies that have become expensive; this performance chasing can have a detrimental impact on future returns. In addition, while robust factors are expected to provide higher returns over the long term, they invariably go through performance cycles and may be out of favor for extended periods.
Importantly, investors utilizing single-factor portfolios should be very aware of factor valuations compared to historical norms and the potential for high tracking error relative to the broad market.
What are multi-factor strategies?
In contrast to single-factor strategies, multi-factor smart beta strategies provide investors with exposure to all or a subset of the value, quality, low volatility, momentum and size factors. Gaining exposure to multiple factors can help investors achieve greater diversification and become less reliant on any one factor to drive returns. Investors have increasingly gravitated to multi-factor approaches for this diversification benefit and potential for a “smoother ride,” as well as the potential for lower tracking error compared to single factor strategies. *
Are all multi-factor strategies designed the same?
No. The methodologies used to create multi-factor equity strategies can be quite different across competing products. These key questions can help to differentiate multi-factor strategies:
- Which factors do the strategies seek to gain exposure to?
- How are the factor portfolios constructed? Are stocks weighted by market capitalization or do the strategies break the link between price and portfolio weight, which may provide additional return potential?
- Are the factors equally weighted, or is there a dynamic allocation process that takes factor expected returns into account?
- Is there a thoughtful implementation process designed to minimize transaction costs?
- Are factor exposures achieved in a transparent, systematic manner or are they subject to market timing attempts that rely on discretionary macroeconomic forecasts?
While there are differences in multi-factor approaches, investors should consider strategies with broad diversification, economic representation, low cost, large capacity and liquidity. *
What is the role of a multi-factor strategy in a portfolio?
Multi-factor smart beta strategies can be used as a complement to or replacement for both passive and traditional active equity allocations, which have historically struggled to deliver consistent excess returns net of fees. ** By providing exposure to a diversified portfolio of robust equity factors, multi-factor strategies offer the potential for higher returns within a core allocation, typically at a lower cost relative to traditional active managers.
What are the risks?
While multi-factor strategies offer potential investor benefits, such as enhanced returns and diversification, it can also come with risks, including factor exposure risk, which means if the factors underperform, it can lead to relatively poor investment performance. Another one to consider is concentration risk, as investing in multi-factor strategies without thoughtful implementation may inadvertently lead to concentration in certain sectors or industries, increasing vulnerability to sector-specific downturns. *
* Diversification cannot ensure a profit or protect against loss in a declining market. It is a strategy used to help mitigate risk.
** Past performance is no guarantee of future results.
Learn more at www.pimco.com/equities.