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Multi-factor investing that combines value, momentum, quality (profitability), or low volatility factors is today’s hot new investment approach. There has been an explosion of multi-factor ETFs recently with nine of the fourteen existing U.S. multi-factor funds coming to market this year, and five of them showing up within the past 60 days. Multi-factor funds may be a good thing, since single factor funds can have some serious drawbacks. However, multi-factor funds can also have their own quirks and issues. If the large variety of factors is thought of as the “factor zoo,” then multi-factor approaches may be the “factor circus” with its own collection of silly clowns, dangerous acrobats, and amusing jugglers. Factor Investing Issues With factor investing in general there are three potential problem areas: tractability, scalability, and volatility. With respect to tractability, it is well-known that value investing can have long periods of serious under performance. This happened in the late 1990s and also somewhat during the past two years. Not all value investors may be willing to watch this happen without losing patience and giving up on their factor portfolios. To a lesser degree, momentum and other factors are also subject to sustained tracking error. Scalability has to do with too much money chasing after too few stocks. Factors perform best when you can focus on those stocks having the strongest factor characteristics. For example, Van Oord (2015) showed that from 1926 through 2014, only the top decile of U.S. momentum stocks outperformed the market. Stocks below the top decile added nothing to strategy results. Yet just two out of the twelve large-cap U.S. equities single factor ETFs only include stocks that are within the top decile of their factor rankings. For example, the oldest and largest single factor value ETFs are iShares S&P 500 Value (NYSEARCA: IVE ), iShares Russell 1000 Value (NYSEARCA: IWD ), and Vanguard Value (NYSEARCA: VTV ). They hold 72%, 69%, and 50% respectively of the stocks that are in their investable universes. This makes them, to a great extent, closet broad index funds with higher fees. Their large sizes ($8.3 billion, $23.5 billion, and $34.6 billion, respectively) may impede them from focusing on just fifty (the top decile of S&P 500 stocks) or one-hundred (the top decile of Russell 1000) value stocks. The same is true with respect to momentum. The largest momentum fund, with over $1 billion in assets, is the AQR Large Cap Momentum Style mutual fund with an expense ratio of 0.45. It holds 532 out of an investable universe of 1000 stocks. This is a far cry from the top decile of momentum stocks. Large amounts of investment capital may make it difficult for single factor funds of all types to focus exclusively on the relatively small number of stocks that appear in their top factor deciles. The third problem for single factor portfolios is increased volatility and high bear market drawdowns that accompany value, momentum, and small cap factors. Trend following filters, such as absolute momentum, can help reduce downside exposure with respect to long-term bear markets, but it does little to alleviate uncomfortable short-term volatility. Trend following is also less effective when applied to value factors than when applied to other factors like momentum. Multi-Factor Solutions All three of these problem areas for single factor investing – tractability, scalability, and volatility – can be significantly reduced by using intelligently constructed multi-factor portfolios. Multiple factors can obviously reduce tracking error, since it is unlikely that several factors will substantially under perform at the same time. As for scalability, if a fund uses four factors instead of just one, it can handle four times the investment capital without eroding its ability to enter and exit the markets. Finally, the volatility and large bear market drawdown associated with value and momentum factors can be reduced by combining these factors with less volatile ones, such as quality and low volatility. However, I intentionally included the words “intelligently constructed” when I referred to the potential benefits of multi-factor portfolios. It surprises me that six out of the fourteen U.S. multi-factor funds include small size as a factor. Sponsors of these funds must have been asleep during the past 25 years when abundant academic research showed that small cap stocks, while giving higher returns, add nothing positive on a risk-adjusted basis because of their high volatility. When combined with value or with value and momentum, which is what all six funds of these funds do, small cap can be particularly undesirable, since it can aggravate already high portfolio volatility and bear market drawdown exposure. It is also surprising that the “premier anomaly,” price momentum, is included in only eight of the fourteen U.S. multi-factor funds. Abundant research has shown that momentum is the most powerful factor for generating positive returns. More sleepy time among fund sponsors? The final issue associated with multi-factor funds is their average annual expense ratio of 42 basis points for what are enhanced index funds. This is higher than the Morningstar US ETF Large Blend Strategic Beta expense ratio of 38 basis points and the Morningstar US ETF Large Blend Index expense ratio of 36 basis points. Until just recently, an investor who wanted multi-factor exposure would have been better off creating it herself by combining the single factor iShares MSCI USA Value Factor, USA Momentum Factor, USA Quality Factor, and USA Minimum Volatility ETFs, since these all have expense ratios of only 15 basis points. New Solution This situation changed dramatically last month when Goldman Sachs entered the ETF business with an offering called Goldman Sachs Active Beta U.S. Large Cap Equity (NYSEARCA: GSLC ). GSLC is the only multi-factor fund having what I consider an optimal mix of factors: value, momentum, quality, and low volatility. Here is a description of how they determine these factors: • Value: The value measurement is a composite of three valuation measures, which consist of book value-to-price, sales-to-price and free cash flow-to-price (earnings-to-price ratios are used for financial stocks or where free cash flow data are not available). • Momentum: The momentum measurement is based on beta- and volatility-adjusted daily returns over an 11-month period ending one month prior to the rebalance date. • Quality: The quality measurement is gross profit divided by total assets or return on equity (ROE) for financial stocks or when gross profit is not available. • Low Volatility: The volatility measurement is defined as the inverse of the standard deviation of past 12-month daily total stock returns. Even though the fund holds 432 stocks out of an investable universe of 500, it uses a weighting scheme (most multi-factor funds with a large number of holdings do the same) that allocates substantially more of its capital to stocks with high factor ratings. GSLC rebalances positions quarterly and uses a turnover minimization technique (especially useful for momentum stocks) of buffer zones to reduce the number of portfolio transactions. I use a similar buffer zone technique myself with some of my more active momentum models. What is especially appealing about GSLC is its low cost structure. The fund came into existence because some of Goldman’s largest clients wanted to invest this way using an ETF wrapper to minimize their tax consequences. Because of this sponsorship, the fund was set up with an annual expense ratio of only 9 basis points. This is the same expense ratio as the biggest and most popular ETF in the world, the SPDR S&P 500 ETF Trust (NYSEARCA: SPY ). GSLC already has $78 million invested in it since coming to market one month ago. GSLC is not an ideal investment from our point of view, since it doesn’t have a trend following filter like absolute momentum to help it avoid severe bear market drawdown. GSLC is also unable to benefit from international diversification during those times when international stocks show greater relative strength than U.S. stocks. However, because of its low cost structure, GSLC might be a good asset to consider along with the S&P 500. If GSLC continues to attract considerable assets so that it has good liquidity and if it performs well relative to the S&P 500 over the next year, I may add GSLC to my dual momentum models. Multi Factor Funds Symbol Factors Assets Stocks Exp Ratio 4 Factor Goldman Sachs Active Beta U.S. Large Cap GSLC Value, Mom, Quality, LoVolty $78 m 432 0.09 ETFS Diversified Factor U.S. Large Cap SBUS Value, Mom, Size, LowVolty $17 m 492 0.40 iShares Factor Select MSCI USA LRGF Value, Mom, Size, LowVolty $5 m 135 0.35 3 Factor SPDR MSCI USA Quality Mix QUS Quality, Value, LowVolty $6 m 624 0.15 JP Morgan Diversified Return U.S. Equity JPUS Value, Mom, Quality $11 m 561 0.29 John Hancock Multifactor Large Cap JHML Size, Value, Profit $79 m 772 0.35 AQR Large Cap Multi-Style (non-ETF) QCELX Value, Mom, Profit $1.2 b 338 0.45 iShares Enhanced U.S. Large Cap IELG Value, Quality, Size $71 m 109 0.18 PowerShares Dynamic Large Cap Value PWV Value, Quality, Mom $927 m 50 0.58 FlexShares U.S. Quality Large Cap Index QLC Quality, Value, Mom $3 m 120 0.32 Gerstein Fisher Multi-Factor Growth Equity (non-ETF) GFMGX Size, Value, Mom $227 m 298 1.03 2 Factor ValueShares Quantitative Value QVAL Value, Quality $47 m 41 0.79 FlexShares Morningstar U.S. Market Factor Tilt TILT Value, Size $740 m 2249 0.27 Cambria Value and Momentum VAMO Value, Mom $3 m 100 0.59 Nothing contained herein should be interpreted as personalized investment advice. Under no circumstances does this information represent a recommendation to buy, sell or hold any security. Users should be aware that all investments carry risk and may lose value. Users of these sites are urged to consult their own independent financial advisors with respect to any investment. Scalper1 News
Scalper1 News