Instead of simply putting single-factor indices together, a new bottom-up style of multi-factor investing instead looks at all stocks in a market at once and assigns them with scores for each factor.
The approach simply ignores stocks that are only strong in one or two factors, and selects for inclusion only those stocks that are seen as good ‘all-rounders’ at the factors the portfolio wishes to track.
According to recent research by Vanguard in Australia the approach, also known as ‘integrated’ multi-factor investing, can offer a number of benefits.
“The method may… reduce turnover versus a top-down approach, because stocks that no longer exhibit very strong sensitivity to one factor do not necessarily have to be sold if they still rank favourably with the other factor(s),” said the report’s authors.
“This process ensure that the chosen stocks are not inadvertently tilted against any of the targeted factors.”
A recent report by FTSE Russell Indices pointed out that the bottom-up approach may be highly capital efficient, since the entire portfolio is being positioned with key factors in mind and single holdings are contributing multiple benefits.
In other words, each pound invested is working for you in multiple ways.
One downside is that investors have to be able to locate an investment portfolio focusing on their preferred factors, but as product proliferation rises this is unlikely to be a problem for long.
Investors wishing to investigate bottom-up, multi-factor investing may wish to look at the FTSE Global Minimum Variance Index series. Another option is the S&P 500 Quality, Value & Momentum Multi-Factor Index.
It can only be a matter of time before a slew of ETFs tracking the UK, European and other major markets in this way become available here at home.
However, there may be problems even with the bottom-up approach. A recent analysis by Corey Hoffstein, co-founder and chief investment officer at Newfound Research, said FTSE’s argument that each invested pound may be working in more than one way falls down in the data.
Hoffstein also argued that the bottom-up approach might degrade the compelling diversification effects that are seen in top-down multi-factor investing, calling it opaque and complex.
Overall, then, for passive investors wishing to target more diverse factors than just plain-vanilla indices there is clearly a place for smart-beta products, and multi-factor investing offers clear performance and diversification benefits.
But at the cutting edge of investing technology the debate continues to rage over which methods work best, and that may rule out hyper-modern approaches for all but the most adventurous investors for now.
