By Andrew Innes, Senior Analyst, S&P Dow Jones Indices
With a wealth of smart beta indices to choose from, market participants may find it difficult to decide when each factor-based strategy is best suited to deliver returns. Is it wise to rely solely on the performance of one factor? If not, what multi-factor approaches could be considered and how effective are they?
Research findings from S&P Dow Jones Indices have determined that market participants seeking to target the systematic equity risk premia associated with single factors should understand that historical performances for each factor have been cyclical and have experienced long drawdowns relative to the market. The active returns of each factor have generally displayed low or negative correlations, as they respond differently to the market environment and economic cycles. Hence, market participants adopting a multi-factor approach may reap considerable diversification benefits. Alternatively, market participants wishing to be selective about single equity factors may want to either have long investment horizons or high conviction in their decisions.
Diversifying factor risk
As an alternative to choosing between equity factors, multi-factor portfolios can be constructed to diversify factor risk. Market participants considering multi-factor investing should explore the differences between the index of indices approach and the stock-level multi-factor approach. Our analysis shows that those wishing to minimize tracking error relative to the benchmark could have experienced higher probabilities of risk-adjusted outperformance over varying time horizons with a multi-factor index of indices approach. However, since exposure to desired secondary factors could be weak in each single-factor index, a multi-factor index of indices may experience some factor exposure dilution.
The factor exposure dilutions inherent when simply holding multiple single-factor indices may be alleviated by opting to combine factor scores at the stock-level. The back-test of the S&P 500 Quality, Value & Momentum Multi-Factor Index has demonstrated superior risk-adjusted returns of 0.73 over the average of the 15-year rolling windows compared to 0.54 for the hypothetical index of indices approach. This supports the view that the stock-level index construction approach may help reduce factor exposure dilutions, but it may come with the cost of increased tracking error (increased to 7.1% from 3.7% for the index of indices).
For market participants without a factor viewpoint, both multi-factor approaches offered a viable alternative to the best-performing single-factor index. With both options offering a balanced exposure across multiple factors, the choice could be simplified to whether one wishes to maximize risk-adjusted returns on an absolute basis or relative to the benchmark. Ultimately, the decision between a multi-factor index of indices or our stock-level selection approach depends on the market participant’s investment objectives.
In conclusion, multi-factor indices may help market participants avoid the potential pitfalls of choosing and timing factors without necessarily missing the upside that the best factor choice may have provided.Download the full report