This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Corey Hoffstein, co-founder and chief investment strategist of Boston-based Newfound Research.
On the cutting edge of investment management, where investors are migrating from a style-box-driven approach to a multifactor approach, there remains a significant debate as to the best way to combine factors in a single portfolio.
The benefit of a multifactor approach can be distilled into a single word: diversification. While most well-known factors have historically exhibited long-term alpha, they can also exhibit significant short-term tracking error. By combining multiple factors into a single portfolio, the volatility of relative performance can be significantly reduced.
Debate exists, however, on the best way to actually build a multifactor portfolio, with two prominent camps.
The Mixed Approach
A mixed approach is one in which a portfolio is built for each target factor individually, and those portfolios are combined as sleeves to create a multifactor portfolio.
For example, let’s assume there is a portfolio trying to provide exposure to value, size, momentum and low-volatility factors. In the mixed approach, the manager would build a value portfolio, a small-cap portfolio, a high momentum portfolio and a low-volatility portfolio. The manager would then combine these four portfolios as sleeves of a single portfolio.
To use the language of a style-box-driven approach, a mixed-approach portfolio seeking both “small cap” and “value” exposure would have a 50% weight to value stocks (regardless of capitalization) and a 50% weight to small-cap stocks (regardless of growth/value classification). You would end up holding the stocks in the following buckets:
Mixed approach managers argue that this approach allows the full spectrum of value and size factors to be introduced. Integrated-approach managers, as we will see later, would argue that the introduction of large-cap stocks or growth stocks dilutes the overall target factor exposures.
Pros of Mixed Approach
- Simple-to-understand approach to portfolio construction
- Each sleeve can seek to independently maximize its target factor exposure
- Turnover in factor portfolio sleeves can be independently managed
Cons of Mixed Approach
- Securities in each sleeve are selected to target only a single-factor exposure and may unintentionally introduce negative exposures to other factors
ETFs Using a Mixed Approach
- Global X Scientific Beta US Equity ETF (SCIU)
- Goldman Sachs ActiveBeta US Large Cap Equity ETF (GSLC)
The Integrated/Composite Approach
The integrated (or composite) approach to building a multifactor portfolio relies on selecting stocks that have high exposures to all the target factors simultaneously.
Let’s assume we are trying to build a multifactor portfolio that targets the same factor exposures as our prior example. In the integrated case, we would try to identify the stocks that simultaneously have high exposure to value, size, momentum and low-volatility factors.
Again, using the language of a style-box-driven approach, a mixed-approach portfolio seeking both “small cap” and “value” exposure would hold the stocks in the small-value bucket:
Integrated approach managers argue that this approach allows for the most highly concentrated exposure without introducing dilutive effects. Mixed managers would argue that this approach risks missing value premium or size premium generated on the large-value or small-growth edges of the spectrum.
Pros of Integrated Approach
- The same dollar can be used to invest in multiple factors, potentially creating leverage
- Potential first-order benefits from identifying stocks with well-rounded factor exposures and avoiding those stocks with factor exposures that cancel each other out
Cons of Integrated Approach
- May avoid securities with the highest factor exposures in favor of those with average exposures across all factors, implicitly diluting overall exposure
- Inefficiencies may be introduced from rebalancing high turnover factors (e.g., momentum) and low turnover factors (e.g., value) on the same horizon.
ETFs Using an Integrated Approach
- JPMorgan Diversified Return US Equity ETF (JPUS)
- FlexShares Morningstar US Market Factor Tilt Index Fund (TILT)
- iShares EDGE MSCI Multifactor USA ETF (LRGF)
- John Hancock Multifactor Large Cap ETF (JHML)
At Newfound, we currently advocate for a mixed approach. Using the first generation of factor ETFs, we employ a “build it yourself” approach in our U.S. Factor Defensive Equity portfolio. We believe in this approach for several reasons:
- To date, the majority of research has substantiated the individual factors as historically reliable ways to generate excess risk-adjusted returns; evidence suggesting that securities with multiple simultaneous factor exposures are better is still lacking.
- Mixing provides extreme transparency in what is held and why. Integration requires the extra step of deciding how much to weight each factor in the overall ranking process.
- Factor portfolios have different turnover levels due to the speed at which the factor premium matures. For example, momentum portfolios tend to be very high turnover, while value portfolios tend to be much lower turnover. Integration runs the risk of the portfolio being influenced most heavily by the highest turnover factor it employs. This difference in turnover may actually negate the argument that holdings in the mixed portfolio cancel each other out, as the expensive stocks held in the momentum portfolio may not be held long enough for value to matter. Similarly, the deep value stock may be held for so long in the value sleeve that the short-term negative momentum has little long-term impact.
- The evidence that integrated approaches create a more efficient use of capital than mixed approaches is lacking.
We believe factor investing can be an incredibly useful tool allowing investors to tap into active management approaches at near-passive beta prices.
Multifactor ETFs take this one step further, creating a turnkey solution for tapping into multiple veins of potential outperformance. Care must be taken, however, in selecting a multifactor approach. Which factors are selected and how the portfolio is built can have a large impact on investor experience.
Newfound Research LLC does not hold any of the ETFs referenced. The company is a Boston-based quantitative asset management firm focused on rules-based, outcome-oriented investment strategies. Newfound specializes in tactical asset allocation and risk management solutions. Newfound offers a full suite of tactical ETF managed portfolios covering global equity, U.S. small-cap equity, multi-asset income, fixed-income and liquid alternative asset classes. For more information about Newfound Research, call us at 617-531-9773, visit us at www.thinknewfound.com or email us at [email protected]. For a list of relevant disclosures, click here.