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The Merits and Methods of Multi-Factor Investing

Are multiple factors better than one?

By Andrew Innes

EXECUTIVE SUMMARY

Merits and Methods of Multi-Factor InvestingWith 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?

  • Single-factor equity strategies (namely quality, value, momentum, and low volatility) may have rewarded market participants with active returns over the long term, but each is susceptible to unique, cyclical drawdowns.
  • Choosing and timing exposures to single factors requires considerable foresight (or luck) to navigate optimally between them.
  • The low correlations between the active returns of each factor generate a diversification benefit in a multi-factor portfolio, which can result in more stable excess returns.
  • Adopting a bottom-up, “stock-level,”1 multi-factor selection process may increase overall exposures to the desired factors when compared with allocating to multiple single-factor portfolios (a top-down “index of indices” approach).2
  • The historical risk/return characteristics of the S&P 500® Quality, Value & Momentum Multi-Factor Index compare favorably to the best-performing single factors over varying time horizons.
  • For market participants wishing to avoid the risk in choosing between single-factor strategies, multi-factor indices may offer a viable alternative without compromising on performance.

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1A “stock-level” approach consists of combining factor scores at the constituent level prior to selection. For example, all stocks within a top-quintile, stock-level, multi-factor index will each have a combination of desired factor characteristics.
2For instance, an “index of indices” portfolio may allocate equal weights (rebalanced semiannually) to each factor index: 25% to the S&P 500 Quality Index, 25% to the S&P 500 Enhanced Value Index, 25% to the S&P 500 Momentum, and 25% to the S&P 500 Low Volatility Index.

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