A Framework for Analysing Multifactor Funds (Part 2)

The framework for evaluating multifactor funds allows investors to focus on the features of these funds’ different approaches to portfolio construction that will have the greatest influence on their factor exposures and ultimately their return and risk profiles.

Alex Bryan 19.07.2018
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In part 1 of this article, we discussed the first three steps in analysing multifactor funds. Here we will continue with the remaining two steps.

4. How does the fund combine its targeted factors?
There are two main approaches to combining multiple factors in a portfolio: mixing and integration. Funds that follow the mixing approach split their portfolios into individual sleeves that each target a distinct factor. For example, if a fund uses the mixing approach to combine value and momentum, it might dedicate half the portfolio to targeting value stocks (ignoring their momentum characteristics) and the other half to momentum (ignoring value). This approach is similar to combining individual factor funds, but it offers the advantage of lower turnover by allowing trades to partially offset as stocks move across sleeves.

The mixing approach is simple, transparent, and facilitates clean performance attribution, making it easy to gauge the impact of each factor on the fund’s performance. That said, it can dilute the fund’s overall factor exposures because there is usually little overlap between the holdings in the different sleeves. For instance, stocks with strong value characteristics often have negative momentum, causing these factor exposures to partially offset in the combined portfolio.

Funds that use the integration approach can achieve stronger factor exposures. They don’t necessarily target the stocks that score the best on any single factor. Rather, they pursue stocks with the best overall combination of factor characteristics. This allows them to allocate the entire portfolio to stocks with exposure to the targeted factors. Sticking with the pairing of value and momentum described earlier, if the fund uses an integration approach to combine these factors, it will allocate the entire portfolio to stocks with both strong value and momentum characteristics. These may not be the cheapest stocks in the market or those that have the strongest momentum, but overall, the integrated portfolio should exhibit stronger value and momentum factor tilts than the mixed version of the same factor pairing.

The downside of the integration approach is that it can lead to greater active risk, which increases both the potential for outperformance as well as underperformance. It is also more complex, and in some cases less transparent, than the mixing approach, making it harder to attribute portfolio performance to distinct factors.

There are a few ways for funds to implement the integration approach, and they are all valid. These include:

  • Portfolio optimization – an optimizer allows a fund to target stocks with multiple desired factor traits, while controlling for many types of risk. Complexity and lack of transparency are the main downsides.
  • Composite scoring and ranking – these funds rank each stock in the selection universe on its overall factor characteristics and target the highest-ranking stocks.
  • Factor-tilting weighting approach—this can be used to emphasize stocks with desired factor characteristics.

5. How aggressively does the fund pursue its targeted factors?
Funds with greater exposure to their targeted factors have greater potential to outperform the market than their less aggressive counterparts when those factors are in favor and greater risk of underperformance when they are not. Just as stocks don’t always outperform bonds, even though they tend to do so over the long term, factors experience their own unique cycles of out- and underperformance versus one another and the broader market. The risk of underperformance is a necessary trade-off to capture the performance advantages factors might offer.
Investors who are comfortable with the risk of underperforming a benchmark (active risk) to capture those potential return advantages should favor funds with pronounced exposure to their targeted factors. Funds with smaller factor exposures are probably more suitable for those who prefer to limit active risk, while keeping the door open to the potential for modest outperformance.

The strength of a multifactor fund’s factor exposures is driven by its:

  • Stock-selection threshold
  • Weighting approach
  • Portfolio constraints
  • Rebalancing frequency
  • Factor timing adjustments (if applicable)

Portfolios with higher thresholds for stock selection should have higher factor exposures and more compactness than those with less demanding criteria. For example, if a fund assigns composite factor scores to all stocks in its selection universe and targets the highest-ranking third, it should have greater exposure to its targeted factors than a fund that filters out the lowest-ranking third.
Funds can also strengthen their factor exposures through their stock-weighting approach. Those that incorporate the strength of each holding’s factor characteristics into their weightings tend to have more-pronounced factor exposures than funds that don’t.

Constraints on sector, country, and stock weightings, turnover, and risk are often beneficial (more on that later), but they can also reduce the strength of a fund’s factor exposures by causing it to own stocks with weaker absolute factor characteristics than it otherwise would.

More-frequent portfolio rebalancing tends to strengthen a fund’s factor exposures. Quickly removing stocks whose factor characteristics have weakened and replacing them with stocks that look better on those metrics can help keep these funds homed in on their targeted factors. However, more turnover also leads to higher transaction costs, so it is important to understand how the index balances these considerations.

Some funds explicitly seek to time their factor exposures based on forecasts of how each factor is expected to perform going forward. The larger these tactical adjustments are, the more aggressive the fund tends to be.


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Alex Bryan

Alex Bryan  Alex Bryan, CFA is the Director of Passive Fund Research with Morningstar.

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