An important evolution within factors has been the rise of multi-factor strategies. As characteristics differ across factors, strategies that are called “multi-factor” may provide different outcomes to investors, and play different roles in portfolios. Small construction differences can make big impacts, even if the names seem similar.
In the first part of my Q&A blog series with Mark Carver, Global Head of Factor Index Products at MSCI, we explored how MSCI constructs their multi-factor indices. In this blog, we discuss Mark’s perspective on the role of factor strategies in portfolios and trends in factor investing.
Matthew: We often hear factor strategies referred to as a blend between active and passive. Can they be a direct replacement for one or the other? Or does it depend on the type of factor strategy?
Mark: It really depends on the investor—I like to use the expression that “where you sit depends on where you stand.” What this means is that for those investors who think any portfolio that weights stocks differently from their market cap is a bet against the market we often see the factor index allocation come from the “active” portfolio. On the other hand, if the investor believes factors are systematic and transparent investments, something like a beta, we observe the funding for the factor allocation coming from the so called passive or index-based portfolio. Both approaches are perfectly reasonable—as the choice is largely based on the way you define and view a factor itself.
Matthew: When taking a multi-factor approach to investing, is there a benefit to having, say, three factors in a single package, or should an investor just buy the factors individually?
Mark: There is a trade-off between costs and control to some extent. Trading costs are a real consideration, since buying the factors individually would involve three trades instead of one if investors execute through a product like the ETFs, (i.e. establishing the position in the strategy that packages factors together) when rebalancing back to the assigned weights of the factor mix. Assuming the same weight to the factors the performance wouldn’t differ materially, assuming the rebalancing is done at the same time as the combined package, but you cannot ignore the trading cost component of this. However, some investors may want to change the weights or set guardrails on the weights to the individual factors which might mean a preference for implementing with the individual factors.
Matthew: We’re frequently asked about factor timing. What’s your viewpoint?
Mark: Timing factors is extremely difficult. When making decisions on timing, you want as many options in play (i.e. market breadth) as possible to reduce the probability that you get it wrong. With factors, you’re talking about timing only the core six factors—value, quality, momentum, volatility, size, and yield, which is quite limited and makes timing very challenging.
There are some factor timing mechanisms designed based on one or multiple signals, such as macroenvironment, valuations, etc. Sometimes different signals may have contradictory conclusions. Given all the challenges, some argue that it’s better to be diversified among factors than trying to get the timing right.
Interestingly enough, being diversified with set rules in effect provides a naive timing impact. When factor performance shifts, a multi-factor approach which sets rebalancing rules in advance will reduce factor exposures with possibly expensive valuations and buy the ones with potentially more attractive valuations as on a relative basis it has not performed as well as the other factors in the mix.
Matthew: What are the trends or concerns in factor investing that everyone should be aware of?
Mark: The biggest trend is the move toward multi-factor. For a long time, investors were using factors as tools to fill gaps in portfolios, so they were very single factor oriented. For example, an investor would add a value factor strategy to a portfolio lacking value exposure. Today, people are using factors more as core exposures, so it serves as the foundation of a portfolio. This naturally leads to a conversation around multi-factors, which may offer diversification benefits.
We’ve also seen greater demand for transparency. We get a lot of questions about index construction and whether the index will perform true to its design. This level of scrutiny is far more intense than it was just two years ago, likely because the number of factor products has grown and they now represent a bigger part of the portfolio. To provide this we’ve spent a lot of time walking clients through index performance as well as the relative drivers based on the methodology or rules that establish the construction of the factor portfolio.
Matthew: Mark, thank you for taking the time to speak with us today. It’s great to get insight and perspective from one of the pioneers in factor investing.