Multi-factor investing works, at its simplest level, by building a portfolio of favoured smart-beta factor trackers on a ‘top-down’ basis, reflecting current factor preferences.
For example, one multi-factor index might be weighted 25% in a low volatility factor index, 50% in a value factor index and 25% in a growth factor index.
Creating such an ‘index of indices’, also known as the ‘top-down’ or ‘mixed’ approach, offers the advantage of reducing the risk of finding yourself in a deep cyclical downturn relative to the broader market.
By only rebalancing the index’s overall weightings between the individual factor indices twice a year, turnover and therefore transaction costs can be kept low.
A study published earlier this week by S&P Dow Jones Indices revealed investors were far more likely to benefit from such an approach compared to single-factor funds over anything but the longest investing timeframes.
“For those with an agnostic view regarding factors, the index of indices represents an alternative approach that fared as well or better than the best-performing single factor over all horizons,” said report author Andrew Innes.
“[In single-factor indices] market participants would have needed significant foresight when allocating tactically between the factors to ensure that they were exposed to the winning factors at the right time.”
But the approach is not without its problems.
Some experts have argued at length that by plugging factor-based indices together they can inadvertently cancel each other out and return the investor to the problems of correlation and lower returns.
This is known as ‘factor exposure dilution’, and occurs if shares selected for their delivery of one particular factor also happen to be detractors from another factor.
Now, there is an innovation threatening to take things further – and it may have the power to truly undermine active investing.
