Note: This article is part of the ETF Trends Strategist Channel
By Joe Smith
Multi-Factor Investing is on the Rise
Multi-factor investing is an increasingly hot topic in the world of ETFs, and a number of ETF sponsors have launched multi-factor ETFs recently to expand on this trend.
Multi-factor ETFs aim to intelligently combine a well-known set of factors, such as Size, Value, Momentum, Minimum Volatility, and Dividend Yield in the formulation of an investable portfolio that benefits from harvesting these risk premiums over longer time horizons. In addition, the benefit of diversification across these factors should deliver superior risk-adjusted returns than traditional benchmark alternatives.
Bayesian Framework of Factor Performance
If history is a guide, then we can look to factor combinations that have traditionally worked better together to further improve upon the current equal-weighted case across factors.
We take a Bayesian view to factor investing to discover insights associated with certain combinations of factors at various periods of outperformance relative to the global equity markets. More specifically, we evaluate the probability of a factor outperforming the benchmark over a one-year window if another factor has outperformed the benchmark over the same time frame.
Which Factor Pairs Work Best Together?
Looking at the results, we find a few points of note. In isolation, Momentum on average has the highest probability of outperforming the benchmark over a rolling one-year period, a success rate of 75% irrespective of other factors. Every other factor’s individual success rate falls to 50-59% with the exception of Minimum Volatility, whose rate is just shy of 49%.
Even more important to note are the comparative results of factors that have worked when others have too. Value shows a success rate of 74% when Size also has outperformed. When Value outperforms, Size succeeds at a lesser rate of 68%. Dividend Yield has a 71% success rate of outperforming when Value outperforms, but Value is only 53% successful in outperforming when Dividend Yield outperforms.
Sources: MSCI, CLS Investments. Analysis of indexes from 12/31/1994 to 3/31/2016. Size is the MSCI AWCI Size Tilt Index; Value is the MSCI ACWI Value-Weighted Index; Momentum is the MSCI ACWI Momentum Index; Minimum Volatility is the MSCI ACWI Minimum Volatility Index; Quality is the MSCI ACWI Quality Index; Dividend Yield is the MSCI ACWI High Dividend Yield Index. All rolling 1 year returns are compared against the 1 year rolling return for the MSCI ACWI IMI.
Defensive factors, such as Quality and Dividend Yield tend to have higher success rates (72% and 69% respectively) when Minimum Volatility outperforms. In contrast, Minimum Volatility outperforms just 59% of the time when Quality outperforms and 64% of the time when Dividend Yield outperforms.
Momentum, however, has the most consistent rate of outperformance when other factors, especially more defensive factors such as Minimum Volatility, Quality, and Dividend Yield, outperform. Momentum on average outperforms at rate of 78% when Minimum Volatility is working, 83% when Quality is outperforming, and 79% when Dividend Yield is in play. Interestingly enough, Momentum also has lower success rates when more offensive factors, such as Size or Value, are working. In each case, Momentum has success rates of just 64-65% when Size or Value outperform.
Key Takeaway: Multi-Factor Investing Can Be Done Intelligently
Based on the analysis presented above, there are a couple of key findings investors should take away. First, each factor analyzed can be paired with certain factors when they are likely to experience periods of persistent outperformance. Size and Value tend to work well together, but more importantly they don’t work universally in lock-step as one would expect.
Second, more defensive factors, such as Minimum Volatility, Quality, and Dividend Yield, tend to succeed primarily when Minimum Volatility outperforms, but they perform less well when Quality or Dividend Yield are ahead of benchmarks.
Finally, Momentum tends to work most consistently across all other factors and achieve its highest success rates when Minimum Volatility, Quality, or Dividend Yield are working. Based on this, a suggestion would be to either pair Momentum with other factors in a portfolio or use Momentum as a signal to identify opportunities with other factors and successfully rotate between them.
In any case, applying Bayesian techniques to assessment and implementation of multi-factor investment strategies can provide a more intuitive approach to harvesting factor risk premiums for institutional investors and investment advisors. Multi-factor investing is still in its infancy but could redefine investors’ thinking about combining individual securities and ETFs for consistent investment outcomes over time.
[related_stories]Disclosure Information
This information is prepared for general information only. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. All opinions expressed herein are subject to change without notice. The graphs and charts contained in this work are for informational purposes only. No graph or chart should be regarded as a guide to investing.