Again, portfolio construction matters. When it comes to multifactor funds, the devil is in the details. Often, the details are many and they are nuanced. Here, we present a framework that will help investors to parse these funds' approaches to portfolio construction. This framework will help investors better understand these funds and (we hope) better manage their own expectation—which is critical to using them well.
1. What is the fund’s selection universe?
The selection universe, also referred to as a parent index, is the collection of potential stocks that a fund whittles down to build its investment portfolio. This is typically a broad index, like the Russell 1000. The selection universe should serve as a benchmark for the fund’s performance. It may also offer insight into the fund’s potential to outperform its parent index and/or category peers. For example, the payoff to most investment factors has historically been the greatest among the smallest stocks. This may be because they are more likely to be mispriced than larger stocks. So—all else equal—funds that start with a universe of large- and mid-cap stocks (as most multifactor funds do) likely have less potential to outperform than those that start with an all-cap universe or a group of small-cap stocks.
2. Which factors does the fund target?
There are only a handful of investment factors that truly matter. These include: