Multi-factor investing, demystified: Part 2
In the world of investing, there’s always a buffet of options to choose from, but there’s no such thing as a free lunch.
That goes for multi-factor investing, too.
As we wrote in part 1 of this series, multi-factor investing has surged in popularity over the past decade, due in large part to its lower cost structure, greater transparency and potential to outperform a passive benchmark. However, like any strategy, it’s not without its pitfalls. For a closer look at a few of the stumbling blocks associated with multi-factor investing—as well as some of the tools and skills we believe are vital to achieving success—let’s go under the hood again with portfolio managers Jordan McCall and Nick Zylkowski.
McCall and Zylkowski break the potential pitfalls into three categories:
- Pitfalls of single-factor portfolios
- Pitfalls of multi-factor portfolios
- Pitfalls without dynamic or active portfolio management
1. Pitfalls of single-factor portfolios
According to McCall and Zylkowski, three common things to watch out for with single-factor portfolios are transparency, simplicity and back-testing risk. Transparency, which is usually a good thing in investing, can backfire when hedge fund managers with smart quantitative investment strategies, for instance, take information published online and use it to track the flows of large institutions that are invested in a particular factor. Hedge funds can then use this information to figure out when a factor is going to be rebalanced and trade before the factor portfolio does, potentially reducing the efficacy of the factor.
With this in mind, it’s wise not to lift the lid too much on the nuances of any given strategy, Zylkowski says. “Here at Russell Investments, we’re happy to share the factors we’re looking at, but we’re not going to tell everyone when we’re trading and exactly how we’re trading our portfolios.”
The relative simplicity of multi-factor investing is also problematic, McCall and Zylkowski explain, because it implies to some that there’s now a simple way to outperform the market. But just because the approach itself is easier for many investors to understand, that doesn’t mean it’s easy to carry out successfully. “If it were really simple to outperform the market, everyone would do it—and then no one would outperform the market anymore,” McCall notes.
For example, while many factor investing and smart beta strategies are relatively simple in their portfolio construction, they can bring unintended additional exposures to the factor that’s being targeted. Case-in-point? Minimum variance (i.e., low volatility) strategies may have large sector exposures and large interest-rate sensitivity, rather than just pure exposure to low volatility. This is why it’s very important to be disciplined and robust, McCall says. Simple as it may seem on the surface, the devil is truly in the details.
The risk of making decisions based on back-testing also looms large with multi-factor investing. Why? “With this approach, there’s the potential for a smart quantitatively minded person to dig into a dataset and generate a strategy that has outperformed in the recent past—or even over a long period of time—without any forward-looking economic or fundamental intuition,” McCall explains. Because of this, there’s a tendency for strategies that are built to maximize a back-test to ultimately disappoint once they’re launched.
This is why, in McCall and Zylkowski’s opinion, it’s crucial when building strategies to specify in advance the factors that appear important, and subsequently test them across multiple time periods and regions to try to avoid this.
2. Pitfalls of multi-factor portfolios
A major concern with multi-factor portfolios is surviving potential underperformance in the short-term. Factor portfolios are typically designed for the long haul—to outperform over a five, 10 or 15-year time horizon, for instance. But in the short-term, any individual factor portfolio can underperform. A good example of this is value and momentum. Very rarely do these two factors outperform (or underperform) at the same time. In fact, says McCall, when value is performing at its best, momentum is usually performing at its worst.
In fact, this happened recently, with some extreme outcomes. While we believe strongly in the value factor over the long-term at Russell Investments, value investing had been beset with challenges since the Global Financial Crisis of 2008. It struggled particularly during 2020 as the COVID-19 pandemic further boosted the attractiveness of mega-cap technology growth strategies that benefited from the mobility restrictions imposed around the world. Since November of 2020, however, value investing has outperformed the market by a wide margin. By maintaining a meaningful exposure to momentum and quality factors during both periods, the return pattern was much smoother than if one was allocated to just a single factor. “This is why we believe that, in order for investors to be able to survive the journey and stick with factor investing, there’s great value in having access to diversifying factors that not only outperform over the long run, but outperform at different times,” McCall emphasizes. In summary, diversification is just as important in factor investing as in more conventional types of investing, he notes.
Another stumbling block is that not all factors can be integrated well together into a portfolio. Investors may go one place for a value factor, another place for a momentum factor and a third place for a low-volatility factor—and then try to force all the factors together when the fit isn’t right. This can result in a poorly designed and weighted portfolio. “When integrating factors, you need to find ones built to actually connect with one another, like Lego pieces,” McCall concludes.
3. Pitfalls of not dynamically managing a factor portfolio
Dynamically managing a factor portfolio is especially important, McCall and Zylkowski believe, for two reasons: the changing correlation structure over time—and crowding.
Going back to the pandemic example, 2020 demonstrates all too well how time impacts a factor. At the beginning of 2021, a momentum factor looked a lot like a growth factor. Today, though, a momentum factor looks much more “balanced”. What does this mean?
“In 2020, you might have thought you had access to growth, momentum, quality and low volatility in a factor portfolio—in other words, that you had access to four factors. But, as it turns out, growth and momentum were the same. So, really you had two, and might have been doubling up on others,” McCall explains.
Crowding, says McCall, is another way of saying a lot of investors are buying a particular security, which can push up valuations. Absent a dynamically managed investing approach, an investor could potentially fall prey to the overvaluation of certain factors that are driven up in price by significant asset flows into the space. 2020 was a prime example, when valuation spreads between the value and growth factors hit unprecedented all-time highs. As mentioned above, since November 2020 this phenomenon has reversed sharply, which is why we believe avoiding crowded trades is an important step in managing an multi-factor portfolio.
What skills and tools are needed to make factor investing work?
Clearly, multi-factor investing is not without its drawbacks. So, how to potentially achieve success as a factor investor?
Zylkowski says it all comes down to being honest with yourself about what the pitfalls are and what your expectations are, as well as having a realistic assumption of what the future holds for different types of factors.
Gaining such a realistic outlook is not easy, he says. At Russell Investments, the portfolio management team strives for this by carrying out what Zylkowski characterizes as a strong academic and research-oriented investment process.
“Essentially, what this means is that before we even look at a number, or run a test, or evaluate a data set, we dig into the academic research. We establish what our expectations are around different types of factors and how we think they should behave in the marketplace—and form an academic basis for this. Then, we test out our hypotheses by applying this framework to an extensive data set to generate factor portfolios we can invest in.”
Doing this also requires getting your hands on a massive amount of data, with metrics for every stock, and every universe, going back decades. It means employing robust and efficient trading and portfolio management systems that allow for such factors to be captured on a daily basis in portfolios.
Sound complex? Make no mistake, it is. “Successful multi-factor investing can’t be done as a side hobby or a peripheral type of activity. It’s not a bolt-on approach,” Zylkowski says. “Rather, it needs to be thought of as its own ecosystem in order to potentially outperform.”
In other words, it’s not a free lunch. But with a disciplined, well-informed process in place, it may end up tasting pretty darn good.
Missed Part 1? Read the blog post here.