By Corey Hoffstein and Justin Sibears, Newfound Research
- The debate for the best way to build a multi-factor portfolio – mixed or integrated – rages on.
- FTSE Russell published a video supporting their choice of an integrated approach, arguing that by using the same dollar to target multiple factors at once, their portfolio makes more efficient use of capital than a mixed approach.
- We decompose the returns of several mixed and integrated multi-factor portfolios and find that integrated portfolios do not necessarily create more capital efficient allocations to factor exposures than their mixed peers.
A colleague sent us a video this week from FTSE Russell, titled Factor Indexing: Avoiding exposure to nothing.
In the video, FTSE Russell outlines their argument for why they prefer an integrated – or composite – multi-factor index construction methodology over a mixed one.
As a reminder, a mixed approach is one in which a portfolio is built for each factor individually, and those portfolios are combined as sleeves to create a multi-factor portfolio. An integrated approach is one in which securities are selected that have high scores across multiple factors, simultaneously.
The primary argument held forth by integration advocates is that in a mixed approach, securities selected for one factor may have negative loadings on another, effectively diluting factor exposures.
For example, the momentum stock sleeve in a mixed approach may, unintentionally, have a negative loading on the value factor. So, when combined with the value sleeve, it dilutes the portfolio’s overall value exposure.
This is a topic we’ve written about many, many times before, and we think the argument ignores a few key points:
- By selecting stocks that score well on multiple factors simultaneously, stocks that do extremely well on a single factor, but not well on others, will be left out. This leads to a pool of securities that are jacks of all trades, but masters of none: a pool that already has diluted factor scores.
- Factors premiums have different maturity lengths (or, put another way, factor portfolios turnover at different rates). How frequently an integrated portfolio is rebalanced will dictate which factors have the largest impact on portfolio construction. As we’ve written about before, we believe this is the fundamental argument behind the Cliff Asness / Rob Arnott debate on factor timing.
FTSE Russell did, however, put forth an interesting new argument. The argument was this: an integrated approach is more capital efficient because the same dollar can be utilized for exposure to multiple factors.
$1, Two Exposures
To explain what FTSE Russell means, we’ll use a very simple example.
Consider the recently launched REX Gold Hedged S&P 500 ETF (GHS) from REX Shares. The idea behind this ETF is to provide more capital efficient exposure to gold for investors.
Previously, to include gold, most retail investors would have to explicitly carve out a slice of their portfolio and allocate to a gold fund. So, for example, an investor who held 100% in the SPDR S&P 500 ETF (SPY) could carve out 5% and by the SPDR Gold Trust ETF (GLD).
The “problem” with this approach is that while it introduces gold, it also dilutes our equity exposure.
GHS overlays the equity exposure with gold futures, providing exposure to both. So now instead of carving out 5% for GLD, an investor can carve out 5% for GHS. In theory, they retain their 100% notional exposure to the S&P 500, but get an additional 5% exposure to gold (well, gold futures, at least).
So does it work?
One way to check is by trying to regress the returns of GHS onto the returns of SPY and GLD. In effect, this tries to find the portfolio of SPY and GLD that best explains the returns of GHS.
Source: Yahoo! Finance. Calculations by Newfound Research.
What we see is that the portfolio that best describes the returns of GHS is 0.75 units of SPY and 0.88 units of GLD.
So not necessarily the perfect 1:1 we were hoping for, but a single dollar invested in GHS is like having a $1.63 portfolio in SPY and GLD.
Note: This is the same math that goes into currency-hedged equity portfolios, which is why we do not generally advocate using them unless you have a view on the currency. For example, $1 invested in a currency-hedged European equity ETF is effectively the same as having $1 invested in un-hedged European equities and shorting $1 notional exposure in EURUSD. You’re effectively layering a second, highly volatile, bet on top of your existing equity exposure.
This is the argument that FTSE Russell is making for an integrated approach. By looking for stocks that have simultaneously strong exposure to multiple factors at once, the same dollar can tap into multiple excess return streams. Furthermore, theoretically, the more factors included in a mixed portfolio, the less capital efficient it becomes.
Does it hold true, though?
The Capital Efficiency of Mixed and Integrated Multi-Factor Approaches