While it is common to diversify holdings with a differentiated mix of
single-factor strategies or investment funds, a more optimal multi-factor
approach begins at the individual security level and considers how various
attributes of one stock should be blended with those of others.
In doing so, investors are able to strike a better balance between targeted
factor exposures and fine tuning these exposures more readily in response
to changing market conditions.
A single factor vs. multi-factor approach
The advantages of combining different factors has been well researched over
the years. This includes the work of Clarke, de Silva and Thorley* whose
studies have shown single factor portfolios to be more volatile and less
consistent over time than portfolios that blend multiple factors which
demonstrate an ability to generate excess relative returns over the long
This stems from the difficulty of timing (and rebalancing) factor
performance due to their inherent cyclicality. Although factors are
anticipated to outperform over the longer term, there will be periods when
they move in or out of favour. In this regard, momentum, quality, and low
volatility have been fairly consistent factor leaders over the past several
years, while value and size have tended to lag. This is in contrast to the
early 2000s when, following the tech wreck, factor returns were notably
marked by strong value outperformance and big losses for momentum.
Moreover, a winning factor in one year can quickly become a loser in the
next. Take momentum, for example. In 2015, it gained more than quality,
size, and value, but in 2016, it trailed the performance of all three of
these factors. Value, meanwhile, did just the opposite – underperforming in
2015, while outperforming in 2016. (See the accompanying table.)
The diversification benefits of these particular style factors are also
related to their unique correlations to one another, as well as the overall
market. Historically, momentum and value have proven to be negatively
correlated to each other, but both have low correlations to quality. Size,
meanwhile, tends to be positively correlated to the overall market, while
low volatility exhibits the opposite relationship with it.
Building a multifactor strategy at the individual stock level
To combine these factors and realize the full potential of their interplay,
many investors will allocate their holdings to a number of single-factor
strategies or funds. This might be as simple as buying a value fund and
combining it with a momentum fund, or it could be more involved to include
the purchase of several funds that each own stocks primarily defined by a
This approach may provide some level of exposure to a predetermined set of
desired factors however this may not be the case if the factors being
combined have negative correlations to one another. Consider an investor
who owns both value and momentum funds. They may actually find their
intended factor exposures have been reduced or cancelled out.
There is also little recognition when combining single-factor strategies to
the fact that individual stocks will generally provide exposure to more
than just one factor so are therefore represented in multiple single-factor
This could result in an over-concentration to a particular security, sector
or geography. A stock with value characteristics, for instance, may also be
a quality stock, or be characterized by its size thus resulting in exposure
to this security across multiple single-factor strategies. As well, these
attributes are constantly changing over time. By not accounting for this,
investors run the risk of being more exposed to one or more factors than
intended and may potentially undermine the benefit of combining them in a
portfolio in the first place, leading to significant unintended risks.
A better multi-factor approach, therefore, is to build a portfolio using
quantitative analysis that starts at the individual security level. This
provides the opportunity to select from a larger universe of stocks versus
just a few single-factor portfolios and considers the combined outcome of
blending individual stocks with differing attributes to ensure alignment
with the desired factors while minimizing unintended exposures.
An important step in this process is the development of a forecasting model
that ranks performance of each stock in a chosen universe from most
attractive to least attractive on a multifactor scorecard.
Such a model can be customized to take into consideration the specific
exposures being sought, incorporating various controls and constraints such
as security, sector and geographic weights to target the intended sources
and magnitude of risk in the portfolio.
Lastly the process needs to be implemented efficiently and constantly
monitored and rebalanced as necessary to ensure the desired exposures are
still being achieved regardless of the changing market environment.
Building a multi-factor portfolio in this way requires a high level of
expertise, resourcing and oversight, not commonly found in many of the
inefficient approaches such as those that combine single factor strategies.
Without proper implementation throughout the process, the expected outcomes
can be reduced or even eliminated.
Done right, a multi-factor approach built from the stock level can help
target desired factor exposures with far more precision, leading to greater
accuracy and flexibility and better outcomes for investors.
* Roger Clarke, Harinda de Silva, and Steven Thorley, “Fundamentals of
Efficient Factor Investing,” Financial Analysts Journal, Volume
72, Number 6 (2016).
is Senior Vice-President, Head of Portfolio Management & Co-Chief
Highstreet Asset Management Inc. He is a registered Advising
Representative in Canada with Highstreet Asset Management Inc., a
subsidiary of AGF Investments
is Chief Investment Officer and Portfolio Manager at FFCM, LLC (FFCM).
AGFiQ Asset Management
(AGFiQ) is a collaboration of investment professionals from Highstreet
Asset Management Inc. (HSAM), a Canadian registered portfolio manager,
and of FFCM, LLC (FFCM), a U.S. registered adviser. This collaboration
makes up the quantitative investment team.
This article first appeared in the Fall 2018 issue of
Your Guide to ETF Investing, published by Brights Roberts Inc. Reprinted with permission
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Commentaries contained herein are provided as a general source of
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