The Case for Multifactor Funds

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vineviz
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The Case for Multifactor Funds

Post by vineviz » Wed Aug 15, 2018 9:12 am

On Morningstar today, Ben Johnson has a new article up called The Case for Multifactor Funds,

It's a pretty good summary of the different factors, their cyclicality, etc. plus includes a few interesting graphs.

Image

Johnson's main case seems to be for diversifying across factors:
Diversifying across complementary factors makes sense. Doing so will mitigate the aforementioned cyclicality associated with owning any one factor in isolation. While this could result in inferior long-term results relative to owning the best-performing factors in isolation, no one knows what those factors will be on an ex ante basis and few have the stomach to stick with them for decades. Perhaps the single most compelling reason to opt for a multi­factor strategy is that it will minimize the biggest risk of all: that investors will bail on a factor, manager, or strategy when it experiences an inevitable period of underperformance.
Last edited by vineviz on Wed Aug 15, 2018 1:15 pm, edited 1 time in total.
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nedsaid
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Re: The Case for Multifactor Funds

Post by nedsaid » Wed Aug 15, 2018 9:14 am

This comes right after another Morningstar article that said there was no evidence that liquid alternatives helped portfolios.
A fool and his money are good for business.

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Re: The Case for Multifactor Funds

Post by jhfenton » Wed Aug 15, 2018 9:57 am

nedsaid wrote:
Wed Aug 15, 2018 9:14 am
This comes right after another Morningstar article that said there was no evidence that liquid alternatives helped portfolios.
Perhaps two completely different things offer different value to a portfolio?

Random Walker
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Re: The Case for Multifactor Funds

Post by Random Walker » Wed Aug 15, 2018 10:11 am

I agree with the premise of diversifying across factors. Chapter 9 of Larry’s factor book shows the benefit by looking at 1/n portfolios diversified across factors. And I’d extrapolate that to the power of diversifying into other alternative uncorrelated sources of return. A more efficient portfolio, although more costly, has less volatility drag.

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Re: The Case for Multifactor Funds

Post by nisiprius » Wed Aug 15, 2018 10:21 am

vineviz, you probably meant to link to The Case for Multifactor Funds.

The link you provided is to an article that could have been entitled "the case for Goldman Sachs ActiveBeta International Equity ETF (GSIE)."
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Re: The Case for Multifactor Funds

Post by garlandwhizzer » Wed Aug 15, 2018 12:33 pm

Direct quote from the same article "The Case for Mulitfactor Funds":

Expectations might matter most. These funds are no magic elixir. Many have limited track records. No matter how sensible their process may seem, nor how low their fees, there’s no guarantee they will deliver better risk-adjusted returns than a plain-vanilla cap-weighted index fund over a full market cycle. Much like single factors or good active managers, these funds will experience their own performance cycles (albeit potentially more-muted ones). Ultimately, investors’ ability to reap the prospective rewards these funds might offer is positively correlated to their ability to stick with them through their inescapable ups and downs.
In theory multi-factor approaches are very appealing, offering the opportunity for outperformance without the increased volatility of single factor approaches which typically go through volatile alternating periods of underperformance and outperformance. In theory multi-factor can produce outperformance with reduced risk, a magic combo. One problem is that if you look at the correlations between the 5 major factors, there are a lot of minus signs. As value factor exposure increases, for example, momentum becomes more negative, as does quality and low volatility. In the end factors can cancel each other out to zero. Constructing the right portfolio factor balance and keeping costs low are critical to success. Ultimately a well constructed multi-factor portfolio may show only slight/modest exposure to multiple factors for this reason. It looks a lot like more like beta than does a heavily tilted single factor portfolio.

Lots of investor dollars quite understandably have been pouring into multi-factor approaches due to their theoretical appeal. Constructing such a portfolio and keeping its costs low is an art that not all managers will master. I suspect some multi-factor funds will succeed in producing better after-cost-risk-adjusted returns and others will fail to so, a lot like other factor and active approaches. IMO we don't have a long enough track record to know whether the average multi-factor fund will be a winner but it is a real possibility. Whether it outperforms or not, multi-factor is very likely to be less volatile than single factor approaches.

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Re: The Case for Multifactor Funds

Post by Random Walker » Wed Aug 15, 2018 1:00 pm

Worthwhile to point out that value, momentum, carry are not limited to just equities; they are present in other asset classes as well. The correlation of the different factors for the same asset class is low. Also, the correlations for the same factor between asset classes is low. Potential strong diversification benefits.

Dave

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vineviz
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Re: The Case for Multifactor Funds

Post by vineviz » Wed Aug 15, 2018 1:16 pm

nisiprius wrote:
Wed Aug 15, 2018 10:21 am
vineviz, you probably meant to link to The Case for Multifactor Funds.

The link you provided is to an article that could have been entitled "the case for Goldman Sachs ActiveBeta International Equity ETF (GSIE)."
Thanks for pointing that out. I did paste the wrong URL into the OP, which I've now corrected.
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Re: The Case for Multifactor Funds

Post by HEDGEFUNDIE » Wed Aug 15, 2018 1:26 pm

garlandwhizzer wrote:
Wed Aug 15, 2018 12:33 pm
One problem is that if you look at the correlations between the 5 major factors, there are a lot of minus signs. As value factor exposure increases, for example, momentum becomes more negative, as does quality and low volatility. In the end factors can cancel each other out to zero.
This has always been my concern with multifactor funds.

But I just listened to the AQR podcast that discussed factors, and they said their approach was not to find a stock that’s an “A” on momentum and a “D” on value and pair it with a second stock that’s the reverse, but rather they try to find two stocks that are “B+” on both factors.

Not sure how well that works in practice...

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Re: The Case for Multifactor Funds

Post by Theoretical » Wed Aug 15, 2018 1:52 pm

Re: the AQR funds. So far it’s shown itself by producing some really serious negative alpha, especially when you add Quality and BAB to the mix.

Interestingly, though we only have daily data, the new Vanguard mutifactor fund has extremely deep loads on value and a modest to moderate momentum but has only a small negative alpha.

For what it’s worth, their multifactor (different factors and more quality) active funds have had ~1 negative alphas pretty consistently.

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Re: The Case for Multifactor Funds

Post by nedsaid » Thu Aug 16, 2018 11:38 am

jhfenton wrote:
Wed Aug 15, 2018 9:57 am
nedsaid wrote:
Wed Aug 15, 2018 9:14 am
This comes right after another Morningstar article that said there was no evidence that liquid alternatives helped portfolios.
Perhaps two completely different things offer different value to a portfolio?
I wouldn't say they are two different things, multi-factor funds are in the universe of alternative funds. Larry Swedroe and his firm Buckingham have recommended multi-factor, alternative lending, portfolio insurance, and reinsurance. Three of Swedroe's recommendations are semi-liquid.
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patrick013
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Re: The Case for Multifactor Funds

Post by patrick013 » Thu Aug 16, 2018 11:52 am

But how many factors are there ? A few or 8 or ten ? I think
more history is needed for some of them. Small seems to be
the most reliable with the most history and positive results
past and current. The others might revert into a bunch of
chaotic market timing. More history needed then.
age in bonds, buy-and-hold, 10 year business cycle

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Re: The Case for Multifactor Funds

Post by jhfenton » Thu Aug 16, 2018 11:54 am

nedsaid wrote:
Thu Aug 16, 2018 11:38 am
jhfenton wrote:
Wed Aug 15, 2018 9:57 am
nedsaid wrote:
Wed Aug 15, 2018 9:14 am
This comes right after another Morningstar article that said there was no evidence that liquid alternatives helped portfolios.
Perhaps two completely different things offer different value to a portfolio?
I wouldn't say they are two different things, multi-factor funds are in the universe of alternative funds. Larry Swedroe and his firm Buckingham have recommended multi-factor, alternative lending, portfolio insurance, and reinsurance. Three of Swedroe's recommendations are semi-liquid.
I disagree, and so would Larry. The multifactor funds we're talking about are pure equity funds. They are not alternative investments in any normal meaning of the word. They simply combine value, momentum, and quality, or a similar mix of traditional equity characteristics into a single fund.

Do you mean multialternative funds? Because those are completely-unrelated creatures.

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Re: The Case for Multifactor Funds

Post by jhfenton » Thu Aug 16, 2018 11:56 am

nedsaid wrote:
Thu Aug 16, 2018 11:38 am
jhfenton wrote:
Wed Aug 15, 2018 9:57 am
nedsaid wrote:
Wed Aug 15, 2018 9:14 am
This comes right after another Morningstar article that said there was no evidence that liquid alternatives helped portfolios.
Perhaps two completely different things offer different value to a portfolio?
I wouldn't say they are two different things, multi-factor funds are in the universe of alternative funds. Larry Swedroe and his firm Buckingham have recommended multi-factor, alternative lending, portfolio insurance, and reinsurance. Three of Swedroe's recommendations are semi-liquid.
I disagree, and so would Larry. The multifactor funds we're talking about are pure equity funds. They are not alternative investments in any normal meaning of the word. They simply combine value, momentum, and quality, or a similar mix of traditional equity characteristics into a single fund.

Do you mean multialternative funds? Because those are completely-unrelated creatures.
patrick013 wrote:
Thu Aug 16, 2018 11:52 am
But how many factors are there ? A few or 8 or ten ? I think
more history is needed for some of them. Small seems to be
the most reliable with the most history and positive results
past and current. The others might revert into a bunch of
chaotic market timing. More history needed then.
There are hundreds of factors disclosed in the literature. But most multifactor funds focus on 2 to 4 of the most well-established. Vanguard's new MF fund combines value, momentum, and quality.

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nedsaid
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Re: The Case for Multifactor Funds

Post by nedsaid » Thu Aug 16, 2018 12:01 pm

jhfenton wrote:
Thu Aug 16, 2018 11:54 am
nedsaid wrote:
Thu Aug 16, 2018 11:38 am
jhfenton wrote:
Wed Aug 15, 2018 9:57 am
nedsaid wrote:
Wed Aug 15, 2018 9:14 am
This comes right after another Morningstar article that said there was no evidence that liquid alternatives helped portfolios.
Perhaps two completely different things offer different value to a portfolio?
I wouldn't say they are two different things, multi-factor funds are in the universe of alternative funds. Larry Swedroe and his firm Buckingham have recommended multi-factor, alternative lending, portfolio insurance, and reinsurance. Three of Swedroe's recommendations are semi-liquid.
I disagree, and so would Larry. The multifactor funds we're talking about are pure equity funds. They are not alternative investments in any normal meaning of the word. They simply combine value, momentum, and quality, or a similar mix of traditional equity characteristics into a single fund.

Do you mean multialternative funds? Because those are completely-unrelated creatures.
What? We had threads discussing QSPIX, the AQR Style Premia fund. This and similar AQR funds are multi-factor though they use leverage and shorting. I think what you are talking about are long only. And yes, you can get ETFs that concentrate on a factor at a time or several at a time in a long-only format. I suppose there are different definitions out there. I would favor a long-only format as shorts and leverage introduce additional risks.
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jhfenton
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Re: The Case for Multifactor Funds

Post by jhfenton » Thu Aug 16, 2018 12:53 pm

nedsaid wrote:
Thu Aug 16, 2018 12:01 pm
What? We had threads discussing QSPIX, the AQR Style Premia fund. This and similar AQR funds are multi-factor though they use leverage and shorting. I think what you are talking about are long only. And yes, you can get ETFs that concentrate on a factor at a time or several at a time in a long-only format. I suppose there are different definitions out there. I would favor a long-only format as shorts and leverage introduce additional risks.
Regardless, QSPIX and similar funds are not the topic of the original article or this discussion. Those are usually categorized as multialternative funds or liquid alternatives. The multifactor funds under discussion in the original article and here are pure long equity factor funds and are considered alternative investments by no one.

I bought VFMFX (Vanguard US Multifactor Admiral Shares) on Day 1 and not long after added it in a second account. I also own EMGF (iShares Edge MSCI Multifactor Emerging Markets ETF) in my HSA at TD Ameritrade.

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Re: The Case for Multifactor Funds

Post by HomerJ » Thu Aug 16, 2018 1:19 pm

HEDGEFUNDIE wrote:
Wed Aug 15, 2018 1:26 pm
garlandwhizzer wrote:
Wed Aug 15, 2018 12:33 pm
One problem is that if you look at the correlations between the 5 major factors, there are a lot of minus signs. As value factor exposure increases, for example, momentum becomes more negative, as does quality and low volatility. In the end factors can cancel each other out to zero.
This has always been my concern with multifactor funds.

But I just listened to the AQR podcast that discussed factors, and they said their approach was not to find a stock that’s an “A” on momentum and a “D” on value and pair it with a second stock that’s the reverse, but rather they try to find two stocks that are “B+” on both factors.

Not sure how well that works in practice...
That's the $64,000 question, right?

Theory looks good.

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Re: The Case for Multifactor Funds

Post by jalbert » Fri Aug 17, 2018 12:30 am

But I just listened to the AQR podcast that discussed factors, and they said their approach was not to find a stock that’s an “A” on momentum and a “D” on value and pair it with a second stock that’s the reverse, but rather they try to find two stocks that are “B+” on both factors
It seems like such a portfolio would not accomplish much if used in conjunction with a market cap portfolio as a tilt because the factors would be too diluted to amount to much. To make use of the strategy it seems like you pretty much have to hold the multifactor fund as your implementation of the asset class in question (US stocks, DM stocks, or EM stocks). This takes a bit of a leap of faith-- the lack of a track record means we don't really have much past data on how the tax efficiency, liquidity, or factor correlations might play out over time.

I also consider Mr. Johnson's position on the robustness of factors across widespread out of sample tests to be oversold.

With non-US equities, exposure to some factors will tilt toward or away from some countries or sectors. For instance, I think a quality tilt for non-US DM stocks will tilt away from Japan, while a DM small-cap tilt will tilt toward Japan, and to a lesser extent Canada. I also think a min-vol tilt for EM will tilt away from oil producing countries. These types of effects could end up being the dominant driver of return of such portfolios, defeating whatever benefit the factor exposure might have.

I think a value tilt for US equities currently tilts toward the financial sector and away from the tech sector.
Index fund investor since 1987.

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