Factor Perspectives

Multifactor strategies

Apr 17, 2018
By Andrew Ang, Holly Framsted

There are two main types of multifactor strategies. How can the difference affect portfolio exposures and returns?

Multifactor strategies build upon the long-standing concept of diversification: that combining exposures to multiple drivers of returns — otherwise known as factors — can help soften the effect of drawdowns and increase the potential for outperformance.

Multifactor investing has grown rapidly over the past few years, from $3.8 billion in assets at the end of 2009 to $70 billion as of March 2018. There were 197 ETFs from 28 fund providers as of March 2018.1 These funds can be constructed quite differently and it can be challenging for investors to compare these offerings.

As anyone who has ever completed a puzzle understands, it is not simply about having the right pieces; it’s also about combining the pieces in the way that achieves the desired outcome. We believe the same is true for types of multifactor portfolios: seemingly simple differences can meaningfully affect portfolio exposures and, ultimately, performance. The two main types of construction are:

  1. Top-down factor allocation — combining single-factor strategies to create a portfolio with multiple factor exposures.
  2. Bottom-up stock selection — screening for stocks with exposure to multiple factors.

Is one method better than the other? We believe so.

Allocating from the top down and combining sleeves of stocks targeting different factors doesn’t necessarily result in a portfolio that is simultaneously tilted toward all factors; rather, the resulting factor exposures are often much closer to neutral.

Bottom-up portfolio construction raises the bar for stocks included in the multifactor portfolio by requiring positive exposure to multiple desired attributes.

Therefore, we believe a bottom-up approach to factor integration may help provide stronger exposures and stronger performance than a top-down combination.

Why multifactor strategies

Individual factors experience cyclicality in performance. Quality, momentum, value and size have each delivered returns in excess of the broad market over the long term, but they have historically performed differently at different stages of the economic cycle based on their different underlying drivers. In other words, they have tended to have low or negative correlations to each other.

For investors who want to benefit from the potential rewards of factor investing, combining these four historically rewarded factors into one strategy may produce more consistent results than investing in single factors.

Top-down: intuitive but dilutive

A top-down approach feels intuitive because the strategy owns the strongest stocks for each individual factor, but it fails to consider how those factors come together in a portfolio.

Top-down construction combines four single-factor strategies. The main benefits of this type of portfolio construction are that it is intuitive and simple to explain. Using single factors as building blocks also makes it easier for tactical investors to tilt toward or away particular factors at desired times.

However, the challenge with a top-down approach is that individual stocks exhibit characteristics of multiple factors, both in positive and negative directions. For example, a stock that is relatively cheap (positive value), might bring another attribute that is not rewarded, such as tending to continue its downward trend (negative momentum). This negative momentum effect could counteract the positive effect of the stocks in the momentum strategy.

Thus, a simple combination of single-factor strategies could dilute desired factor exposures.

Bottom-up: complex but stronger

The bottom-up approach invests in securities based on the sum of their desirable qualities and may result in a portfolio with stronger exposures to all targeted factors.

Bottom-up construction screens for a diversified mix of companies that exhibit multiple performance drivers. For example, one strategy might target companies that are simultaneously smaller, underpriced, trending upward and have strong balance sheets.

This is a more complex approach than top-down construction. It requires a careful evaluation of each security that could be included and is likely to result in a more selective, concentrated portfolio of stocks. However, it also allows the manager to fine-tune factor, sector and risk exposures that might be more difficult to control in the simpler top-down approach.

A bottom-up multifactor stock selection approach tends to assign higher weights to stocks with multiple positive exposures to targeted factors. In contrast to a top-down strategy, it’s less likely to hold stocks with high exposures to a single factor.

This process also makes it easier to manage exposure to other drivers of risk and return, such as liquidity and sector exposures. This has the potential to help mitigate unintended portfolio bets and provide purer exposure to desired factors.

Conclusion

For an investor seeking returns in excess of the market over the long term, a strategy that combines factors may be a good choice. Multifactor ETFs can deliver this type of strategy in a low-cost, transparent and tax-efficient wrapper.

But multifactor ETFs are not created equal. As these strategies continue to gather attention, assets and competitors, it becomes increasingly crucial for investors to research how the pieces are assembled. A bottom-up approach to factor integration may provide stronger exposures and stronger performance potential than a top-down combination of factor indexes.

Andrew Ang
Head of Factor Investing Strategies
Andrew Ang, PhD, Managing Director, coordinates BlackRock’s efforts in factor investing. He leads BlackRock’s Factor-Based Strategies Group which manages macro ...
Smart Beta Senior Strategist
Holly Framsted, CFA, leads the U.S. smart beta product team.