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An Examination of Different Approaches to Factor Combination (Part 2)

Let’s look at how the isolated approach and integrated approach have flared

In part 2, we will look at how the isolated approach and integrated approach have flared.

Isolate or Integrate?
The closest approximation of an apples-to-apples comparison we can arrive at for assessing the relative merit of each approach centers around the benchmark of the iShares Edge MSCI Multi­factor USA (LRGF, listed in the U.S.). LRGF tracks the MSCI USA Diversified Multiple-Factor Index, or DMF. The index targets stocks based on their exposure to the value, size, quality, and momentum factors. The index integrates factor signals to select and assign weightings to its holdings. Although LRGF launched in April 2015, MSCI publishes historical values for the index dating back to December 1998. We also have historical values for each of the four single-factor indexes that proxy the factors targeted by the multifactor index. Thus, we can construct a hypothetical portfolio that equal-weights the single-factor indexes and matches DMF’s rebalancing dates (end of May and November) as a proxy for a version of DMF that employs an isolated approach to combining factors.

While this is a cleaner comparison than a side-by-side of LRGF and the Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF (GSLC, listed in the U.S.), there are a few caveats. Most importantly, DMF uses an optimizer to construct its integrated portfolio, while our proxy portfolio does not. The optimizer aims to maximize the index’s factor tilts while matching the risk level of its parent index: the MSCI USA Index. Also, the optimizer layers on constraints. For example, it limits DMF’s turnover and individual stock and sector tilts relative to its parent index. It also limits the index’s exposure to nontar­geted factors. Additionally, it is important to note that DMF measures three of the four factors it seeks to exploit in the same manner as the associated single-factor indexes that form our proxy portfolio. However, DMF and the MSCI USA Momentum Index measure momentum slightly differently. Specifically, the momentum index risk-adjusts stocks’ momentum scores while DMF does not. With those caveats covered, let’s look at the results.

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About Author

Adam McCullough, CFA  Adam McCullough, CFA, is an Analyst on Morningstar’s Manager Research Team, covering passive strategies.

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