Is a multi-factor approach preferable during extreme market conditions?

Scott Longley

a digital clock showing time

A misattributed quote from Chinese Premier Zhou Enlai when asked about the implications of the French Revolution was that it's ‘too early to tell’ and might also be a good response to how the financial markets have performed since the extent of the coronavirus disruption became evident.

Yet, while the various authorities are still very much in the early stages of picking up the pieces of a severely damaged global economy, it is possible to discern some differences in factor performance at this early stage.

One approach that has grown in popularity in recent years is multi-factor investing. According to a FTSE Russell survey, the number of institutional investors that use a multi-factor strategy jumped to 71% in 2019, up from 49% the previous year.

In theory, the strategy makes perfect sense. By combining a number of academically-proven factors with empirical evidence behind them such as value and size in a portfolio, it removes the need for investors to try and time when a factor will outperform.

Furthermore, the strategy also minimises the period of underperformance for any single factor. To take an obvious example, value has largely consistently underperformed over the past decade.

In a market downturn, diversifying exposure to single factors should be a key consideration when managing risk so a multi-factor strategy could be preferable.

However, during the recent coronavirus turmoil where global markets suffered their worst quarter since the Global Financial Crisis in 2008, a multi-factor approach lagged behind the broader market.

According to data from Research Affiliates, the RAFI Multi-Factor Developed index is down 29.2% year-to-date, as of 29 March, versus 26.1% for its market-cap equivalent.

FundPerf YTD (%)RAFI Multi-Factor Developed Index-29.2RAFI Value Factor Developed Index-37.2RAFI Low Volatility Factor Developed Index-24.1RAFI Quality Factor Developed Index-26.9RAFI Size Factor Developed index-33.6RA Momentum Factor Global Index-25.3Capitalization Weighted Market Performance-26.1

Source: Research Affiliates

Taking a closer look at the historical performance of a multi-factor strategy, it shows a similar story of underperformance versus the broader market (see graph below).


Source: FactorResearch

Nicolas Rabener, managing director of FactorResearch, says the underperformance can partially be attributed to the high fees these products offer.

Factor-based ETFs typically have a total expense ratio (TER) between 0.09% and 0.70%, according to data from FactorResearch, which eats away at returns over a long time horizon.

However, factors such as value, in general, have suffered in recent years which can also be attributed to the consistent underperformance.

“Although the factor selection and portfolio construction of these products can be challenged and improved, there is no easy fix for the lack of performance,” Rabener continued. “Common factors such as value and momentum struggled to generate attractive returns over the last decade.

“It is difficult to produce a delicious dish even with a great recipe when the basic ingredients lack flavour.”

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