By Jack Forehand, CFA, CFP® (@practicalquant) —
Many investors tend to have a style that they gravitate toward because it makes the most intuitive sense to them. And when it comes to building their portfolios, they tend to focus on that style.
For me, that style is value. It just makes sense to me to try to pay less for a dollar of earnings or cash flow. Because of this belief, over my history as an investor, I have tended to have significant exposure to value. But there is a problem with this approach. That problem is that value isn’t the only factor that works. Momentum has significant academic research to back it up. Quality and profitability do as well. And they have the advantage of often working at different times than value is working.
We interviewed Andy Berkin, the co-author of the book “The Complete Guide to Factor Investing” for our podcast this week and we discussed the topic of multi-factor investing. Andy referenced the chart below from the book in the interview. It does as good of a job of any I have seen at illustrating how hard factor investing can be, but also why using a multi-factor approach is a no brainer for most investors.
The chart shows the percentage of time that any given factor underperforms over various time periods. As you can see, the individual factors all underperform a lot over shorter term time periods. That percentage falls as the time periods expand. But even at 10 years, all the factors had periods where they didn’t work.
The magic of multi-factor investing comes in when you look at the P1 through P3 rows. Each of those represents a blend of the other factors. The specifics of those blends is not that important for this discussion so I won’t focus on that, but the results are pretty amazing. By combining factors, the chances of underperforming in any one year go down a lot. They go down even more at 3 years. And by 5 years they are almost eliminated.
Blending factors that have strong long-term track records, but also tend to work at different times, effectively results in a free lunch by reducing risk without reducing return.
But the decision to blend factors is the easy part. The hard part is how to do it.
The Two Major Approaches to Multi-Factor Investing
There are two major approaches to building multi-factor portfolios. Different people call them different things, but in general the first method involves treating each factor as a separate portfolio and then combining them together (the sleeve approach), and the second involves using the factors in unison (integration).
Let’s look at a simple example. If I want to build a 20-stock portfolio using only value and momentum, I could do that in one of two ways. Using the sleeve approach, I could select 10 stocks with the highest momentum scores and 10 stocks with the highest value scores. I could then just combine those two portfolios to build my 20-stock portfolio.
Using the integration approach, I would look for stocks with elements of both value and momentum. For example, I might rank all stocks in my database using value and then rank them using momentum and include the stocks with the best combined score in my portfolio. In the real world, integration can be much more complicated than that, but that is the general idea.
So which approach is better?
If you are looking for an answer to that question, I unfortunately won’t be able to provide it. One of the general rules I use in investing is that whenever there are smarter people than me on both sides of any given argument, there probably isn’t a correct answer. And I think that is the case here.
The Integrated Approach
But that doesn’t mean each doesn’t have its advantages. The integration method typically maintains higher average scores across the factors because all the factors are considered in the integration process. In other words, you are less likely to have a situation where your value stocks have very low momentum scores and vice versa. Turnover is also likely to be lower. Sheridan Titman, Gregg Fisher and Ronnie Shah discussed this in their 2016 paper “Combining Value and Momentum”.
They explained it the following way:
Our analysis of long-only strategies illustrates how a strategy that simultaneously incorporates both value and momentum outperforms a strategy that combines pure-play value and momentum portfolios that are formed independently. There are two advantages of the simultaneous strategy. The first is the reduction in transaction costs; the second is better utilization of unfavorable value and momentum information in a long-only portfolio
The Sleeve Approach
The sleeve approach also has its advantages. The major one is that it allows a portfolio to retain more pure factor exposures in each sleeve. Whenever you start looking at additional factor exposures, it is likely to at least somewhat reduce your exposure to your original factor. For example, if I am looking for the cheapest stocks using a value strategy, but then decide that I want to require a minimum level of quality, it is likely that the resulting portfolio will have less exposure to value than a portfolio without that constraint. Another advantage is that it can allow an investor to more directly control their factor exposures. For example, if I want a portfolio that is 50% value and 50% momentum, I can just use one sleeve of value stocks and a separate momentum sleeve and make each half of my portfolio.
Jack Vogel of Alpha Architect summed up the benefits of the sleeve approach well in a 2005 article he wrote:
The evidence suggests that we keep highly active exposures to value and momentum in their purest forms (assuming we are doing high-conviction non-watered down versions of the anomalies). Blending the strategy dilutes the benefit of value and momentum portfolios. The summary of the benefits of a pure value and a pure momentum approach can be summarized as follows:
- Easier ex-post assessment
- E.g., if we mix and match value/momentum it is more difficult to identify the drivers of performance after the fact.
- Stronger portfolio diversification benefits.
- Pure value and pure momentum strategies have lower correlations than “blended” versions.
- Stronger expected performance.
- Running pure value and pure momentum in highly active forms generates higher expected performance than blended systems.
A Question Without a Definitive Answer
In the end, I don’t think there is one correct way to build a multi-factor portfolio. Each method has both its pros and cons. Given the strong benefits of using multiple factors, the most important decision is likely the decision to do it in the first place rather than the method that is used.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.
