What exactly is a factor? According to the strategists, factors should help investors generate a higher Sharpe Ratio or higher risk-adjusted return than the market, the improved risk-adjusted returns must be economically meaningful, the higher risk-adjusted returns must be persistent and there also needs to be an intuitive economic rationale to back up the strategy.
There are now a number of single factor and multi-factor ETFs available, which may leave investors wondering which is right for them. Deutsche Asset Management contends that the “right” number of factors is subjective, so investors will have to determine for themselves if those factors are factors you believes in and want exposure to, the factors complement a portfolio and won’t increase correlation among holdings, and the methodology in combining multiple factors makes sense.
“Another way of looking at the question of the right number of factors to consider is that investors ultimately face a trade-off with the number that they include,” the DAM strategists said. “Too few, though simple, risks leaving strong incremental drivers of equity returns ‘on the table.’ Too many risk additional complexity for the sake of, probably quite rapidly, diminishing marginal excess return.”
When combining multiple factors, an ETF may take an additive or multiplicative approach. An additive approach would just equally weight the various factors, but this approach runs the risk of diluting factor exposure. The multiplicative approach would overweight stocks that tend to exhibit the stocks with the combined various factors, which may lead to more concentrated factor bets.
For more information on factor-based strategies, visit our smart beta category.