Multi-factor investing, demystified: Part 1
Fifteen years ago, factor investing was a fringe activity. Today, it has surged in popularity, as more and more investors seek ways to unearth additional returns. Despite its rapid rise, however, there remains confusion over what specifically multi-factor investing entails—and exactly how it can help boost returns. To dive more deeply into this, we recently sat down for a chat with portfolio managers Jordan McCall and Nick Zylkowski, who manage our Multi-Factor strategies.
We explore the topic up close, answering questions such as: What is a factor? What are some common factors? What is multi-factor investing? Why is multi-factor investing so popular today? The rest of our conversation, which we’ll summarize in another blog post, focused on some of the stumbling blocks seen in multi-factor investing, as well as the skills we view as instrumental to carrying out this approach successfully.
What is a factor?
In order to truly understand multi-factor investing, it’s helpful to first know what is meant by a factor. At its core, a factor is a characteristic of a security that’s shared with other securities. In other words, it’s a specific characteristic that multiple securities have in common. Zylkowski likes to think about it in cinematic terms: “How would you go about categorizing different types of movies? You’d group them in a certain way: as dramas, comedies, blockbusters or horror flicks—each a specific characteristic inherent in a film. In a similar vein, we can lump the characteristics of securities and investments into specific groupings as well. We call these factors.” Once a particular factor has been defined, measured and captured, an investor can then integrate it into his or her portfolio.
Types of factors
What exactly can be classified as a factor? “Well, technically, anything—even the letter of the alphabet that a stock begins with,” explains McCall. “In actuality, though, we believe you need a fundamentally structured rationale for why a specific factor should be included in an investing strategy.” In other words, why does X factor of a security or an investment exhibit a behavioral bias that drives it to outperform over time? Or, why does such a factor have some kind of risk premium associated with it that can reward investors over a given time horizon?
Common factorsSome of the most common factors we see in multi-factor investing strategies are value, momentum, quality and low volatility. What in particular makes each of these factors useful? Zylkowski takes us under the hood.
- Value: This factor captures the fact that humans tend to be overconfident and overestimate what’s going to happen in the future. Because of this, stocks tend to become expensive as investors overestimate what a company will be earning in the future. On the flip side, humans also tend to overestimate the struggles or difficulties of a company in a given timeframe, which can lead to stocks becoming discounted or shunned.
- Momentum: Investors like to buy things that go up in price. Who doesn’t? So, the more a stock goes up, the more it tends to continue climbing, because of what we call the crowding nature inherent in all of us. Think about it. Where are you likely to feel more comfortable: in a crowd or totally alone? A crowd, right? There’s a sense of comfort that comes from being packed together with everyone else—and that translates into the investment industry, too. We see this all the time in the stock market: everyone piles on to what seems to be a winning proposition. After all, who wants to miss out on a bandwagon stock that’s continuing to rally?
- Quality: What’s often branded as boring tends to be ignored or neglected in lieu of the latest, flashiest newcomers on the block. With any flashy trend or fad, what is “in” today often quickly becomes tomorrow’s relic. Because of this, we’ve observed that, over time, safe, stable companies that have strong balance sheets and consistent earnings companies typically offer a more consistent return proposition for investors.
- Low Volatility: Investors get nervous when there are wild market swings. It's hard to just sit back and watch the market at those times, especially when the stocks you own are falling sharply. Many of us just pull out of the market altogether, and that can mean we miss out on any potential rallies. Low volatility-based investment strategies focus on identifying companies that have more stable return patterns than the broader market.
You’ll note that these four factors tie back to some sort of behavioral or investor bias or preference. Incorporating these elements to enhance the positioning of a portfolio is what multi-factor investing is all about.
Multi-factor investing, defined
So, how to define multi-factor investing? Simply put, it’s a strategy that targets exposure to the basic components of market returns—i.e., value, momentum, quality, etc.—in an effort to help maximize a portfolio’s return potential and manage its risk, at a lower cost than active management. We think of multi-factor investing as a multi-pronged strategy, with three main steps:
- Determining the factors to focus on
- Deciding how to translate these factors into an investable portfolio
- Deciding how to choose allocations, over time, to these factors. i.e., is now a good time for more value exposure? Or, rather, is it a better time to have an opportunistic allocation to a growth factor?
A bit of a caveat: While the factor you choose is important, it sometimes may not be as important as the other decisions you might make in your investing strategy. For instance, Zylkowski explains “how you weight, construct or trade a portfolio makes a tremendous difference. These decisions are often just, if not more, impactful as factor solutions.”
Why is multi-factor investing so relevant in today’s market environment?
Zylkowski and McCall point to three reasons for multi-factor investing’s popularity today:
- It’s a rules-based exposure. That’s a simple way of saying that these strategies tend to be transparent—and relatively simple to explain. From an investor’s standpoint, it’s typically easier to see and understand what it is that’s being invested in. Who doesn’t like knowing what they’ve purchased—what the ingredients in the package are, so to speak?
- It has the potential to outperform a passive benchmark. A disciplined, rules-based exposure to factor investing has the potential to exploit the behavioral biases of a typical investor (i.e., knowing how investors tend to overreact or underreact to certain market information and news)—thereby potentially delivering excess returns over the long run.
- It can be delivered at an attractive total cost that’s typically cheaper than full-blown active management. There’s really no arguing over the appeal of lower costs, as fees continue to be a major focal point of the investing public.