Why Multifactor Strategies Trump Individual Factors

Kal Ghayur: My pleasure. Thank you for having me.

McCullough: Let's start off from a high level. Single-factor funds such as value, momentum, quality--we understand the attributes of these factors and why they might help a portfolio from a risk or a return perspective. But a multifactor fund combines these into one single fund. What are some benefits that investors get from multifactor funds they can't get from these single-factor portfolios?

Ghayur: The basic premise for constructing multifactor funds is that individual factors can go in and out of favor. So, we know, for instance, that value investing works in the long run, but over shorter periods of time, it can go out of favor and when it does, investors experience large losses over prolonged periods of time. Individual factors depict this level of cyclicality. But what is great is that individual factors also have low or negative correlations between them. When value is underperforming, momentum might be outperforming the market, or low volatility might be outperforming the market. Because of those correlation attributes what happens is that when you mix the factors, combine multiple factors in one strategy, it reduces the risk of the strategy because of these correlation attributes, and as a result--while keeping the return--so as a result, you have the same return, reduced risk, and the risk-adjusted returns go up.

One other really important aspect of multifactor investing is that when it comes to factor investing in general, we know that factors work in the long run. It's very much like the equity market, the equity risk premium. If you want to earn the equity risk premium, you have to stay invested for the long run. What that means is that when the equity market is underperforming and you have a 50% drawdown in the market, you've got to stay invested.

With factor investing the problem is as follows. When you invest in individual factors and they underperform by a lot relative to the market, it makes staying the course, remaining invested, really difficult for investors.

McCullough: Multifactor funds offer a smoother ride then for investors?

Ghayur: Exactly. So, because they limit the underperformance risk, they potentially improve your ability and investors' ability to stay invested. And if you can stay the course, stay invested, then you have a better chance of capturing the factor premia over time.

McCullough: The low correlations keep investors in the fund to get the smoother return, but at the same time the sum of the parts is greater than the whole because it's able to benefit from the correlations between these factor exposures.

Ghayur: Yeah, in risk-adjusted terms.

McCullough: Risk-adjusted, exactly.

Ghayur: Yes. Yes.

McCullough: Now that we have the concept of multi-factor funds we know why we would want to do this, what are some construction methods of multifactor funds? What are ways to combine factor portfolios into one portfolio?

Ghayur: The conceptual framework for multifactor funds is very easy. We've just laid it out. However, the next step of choosing a multifactor fund becomes much more complicated for investors. There are many different decisions that investors need to consider. For example, which factors to combine. Should we combine value with momentum? Should we have value, momentum, quality? Should we have low vol in there as well? What about small cap, size, and so on. That's the first level of decision making that goes into the consideration of a fund.

McCullough: Choose the factors.

Ghayur: Choose the factors.

McCullough: OK.

Ghayur: And the choice of the factor tends to be driven or in our opinion, should be driven by their correlation attributes. Don't choose factors that are highly correlated because in a diversification framework they are not going to contribute much.

McCullough: Less beneficial?

Ghayur: Yes, exactly.

McCullough: OK.

Ghayur: So, that's the choice of the factors. Then second is, what particular methodology is being employed to capture those factors. For example, what weighting scheme is being employed. The weighting scheme is important because the only reason why you are investing in the factor is because you believe that that factor gives you a premia, return premium, over time and the only way you are going to catch that or capture that is if you can capture the factor efficiently. So, an efficient exposure to the factor is critical in factor investing obviously.

McCullough: Makes sense.

Ghayur: The weighting scheme has to be true to that particular investment objective. Now, other than the choice of factor, the choice of the weighting scheme, there are certain other attributes that different investment processes will provide that investors may consider more or less important.

For example, implementation is absolutely key. We want to keep implementation costs down when we implement factor investing. Factors over time will give you the return and risk that they will. The one thing that is in your control is how you capture those risk-return characteristics, the implementation of it. If you can keep the implementation costs down, you may have an advantage. What does that mean? That means keeping turnover down; that means having high diversification in the portfolio. The combination of turnover and diversification determines the capacity of the strategy. And the capacity of the strategy has an impact on implementation costs as well. The management fee, how much are you paying to gain access to a strategy …

McCullough: You want lower costs, right?

Ghayur: You want lower costs. Those are some of the considerations that investors will have to consider.

McCullough: It's very useful. With multifactor funds there's a lot to consider, there's a lot going on. Thankfully, we have Kal here to give us some insight into multifactor funds, and we appreciate your comments today. Thank you for the time.

Ghayur: Thank you. Thank you for having me.

McCullough: With Morningstar, I'm Adam McCullough.