Looking at the investment landscape through multifactor glasses may be controversial, but it's a controversy with decades of history.
In the 1970s, Barr Rosenberg was routinely slicing and dicing equity markets into a variety of narrowly focused betas. Barr's better betas, as they were known, offered institutional clients a high degree of precision for customizing portfolios in the quest to earn higher risk-adjusted returns. The allure and mystique surrounding one of money management's first rocket scientists was captured in a headline from the cover of a 1978 issue of Institutional Investor: "Who is Barr Rosenberg, and what the hell is he talking about?"
Investors are still asking questions about multifactor models, but the topic is no longer obscure or the province of a select group of institutional investors. Decomposing the broad stock market beta into constituent risk factors is old hat in the 21st century. What's new is the growing appetite for repackaging factors beyond the usual suspects in ETFs and index mutual funds. Ready or not, the financial industry is offering the masses a wider selection of narrowly defined betas in a new generation of publicly traded products.
The trend is still young, but new ETFs and index mutual funds in recent years that formally target price momentum and volatility are a sign of things to come. So is the rise of freshly minted investable factor indices from Russell Investments, MSCI Barra, and other vendors.
The broader message is that indexing is moving past the standard beta carve-ups, such as small- vs. large-cap equities and value vs. growth stocks. A new era of factor-based indexing is dawning, and it promises to be far more nuanced and complicated. The question is whether it'll also be productive for investing generally. Yes, the optimists argue. A more granular wave of factor indexing will redefine the terms of portfolio design and deliver improved results.
"It's a quantum leap in terms of engineering the portfolio," says Harindra de Silva, president of Analytic Investors, a quantitative money manager in Los Angeles. "I think you'll move from asset allocation to factor allocation."
Adding factor allocation to the traditional asset allocation framework certainly widens the possibilities for adding value. More risk factors equates with a richer opportunity set for exploiting the rebalancing process.
But there are still no guarantees. The potential for improved results in a multifactor world comes at a price of greater complexity. That's no idle threat. Complication can raise the odds of mistakes.
Meantime, returns are still a zero sum game, regardless of how many betas populate your portfolio strategy. The past several decades have already witnessed an explosion in the list of inexpensive beta choices via ETFs and index mutual funds. A variety of strategies and asset classes that were considered beyond the reach of the average investor in, say, 1995, are common in 2011. Long/short equity funds and emerging market bonds denominated in local currencies, for example, are no longer novelties, thanks to ETFs. Yet it's debatable if returns are materially better for the average investor today vs. a generation ago.
This much you can count on: Success in a multifactor world, as in every other aspect of money management, will be financed by failure. Market-beating returns for some exist because of below-average performance elsewhere. As always, much depends on who's managing the allocation.
For those with above-average skills and higher risk tolerance, the next-generation of ETFs offers an intriguing opportunity for triumph with dynamic asset allocation. Of course, not everyone's above average, even if most investors and strategists think otherwise.
Beyond One Beta
A key motivation for targeting multiple risk factors in portfolio design is recognizing the limits of using just one.
The broad market beta does the heavy lifting for explaining the link between risk and return, according to the capital asset pricing model (CAPM). But if CAPM worked as promised, one beta would suffice for explaining risk and return. More exposure to market beta would bring higher return; less exposure would mean lower return.
CAPM's embedded message: Don't waste your time with factors other than market beta. It's an elegant story, and it simplifies portfolio design and management-if it works. But it doesn't, at least not completely. You'll probably do fine in the long run with a one-beta strategy. But as the volatility of recent years reminds, the long run may be too long for some investors.
Even if you have the stomach for sitting tight over ten or 20 years, the risk and return story isn't as simple as CAPM suggests. Decades of empirical research show that there are other risk factors beyond market beta driving performance. In fact, the risk-return story is teeming with factor narratives. The concept of one dominant beta isn't dead, but it's no longer alone. In the long run, only a handful of the factors are expected to generate sizable gains. But in the short and medium terms, a world of multiple betas offers a dazzling array of performance possibilities.
Parsing the market into industry factors, for instance, is now standard, with dozens of funds catering to the niche. Another popular lens for deciphering the equity market is the multifactor model originally outlined in the 1990s by professors Eugene Fama and Ken French. The single-market beta isn't abandoned in the Fama-French 3-factor model, but it's supplemented with style (value vs. growth) and size (small vs. large) factors. Collectively, the trio does a better job of describing the cross section of equity returns compared with CAPM's one-factor paradigm.
No wonder that the population of mutual funds and ETFs dedicated to small caps, for instance, exceeds 1,600 in Morningstar Principia's database. That's a sea change from 20 years ago, when the product choices were limited and the argument for giving small stocks a seat at the asset allocation table was still a radical idea. Style funds tied to value and growth are now teeming with choices as well. But if you think that factor-based investing has settled into a quiet middle age, think again.
A Bull Market For Factors
The supply of factor-based index funds is still limited relative to the possibilities. Most of the betas that academics have identified aren't available in anything close to pure form short of running strategies on your own. That's probably a good thing, since many of these factors are far too speculative for use outside of trading shops. But some are worthy of a closer look and the financial industry is increasingly intent on exploring the possibilities.
Consider the expanding list of market volatility exchange-traded products. There are more than a dozen linked to the VIX Index, which tracks expected volatility for the U.S. stock market (S&P 500). What's the rationale for treating volatility as a separate asset class? The answer starts with recognizing the systematic connection between volatility and return-a relation that's been called the "first fundamental law of finance," according to a Journal of Finance article from a few years ago. The link isn't stable, though it's somewhat predictable.
Compared with forecasting return directly, volatility trends appear relatively transparent. Bull markets tend to accompany low and/or falling volatility; bear markets often bring the opposite. In other words, volatility has an expected return that's negatively correlated with the stock market's performance. This fairly steady relationship suggests that volatility can be useful as a hedge or as a tactical overlay.
Volatility is just one factor, of course. In fact, the potential for new factor products is anything but limited. There's an active debate about which factors lend themselves to securitization, or deserve attention at all. But most analysts agree that the possibilities extend well beyond the standard choices of industry, capitalization and style (value vs. growth).
A study last year in The Journal of Portfolio Management lists more than a dozen factors, including volatility, momentum, earnings yield, currency sensitivity and interest-rate sensitivity. Several exhibit persistence and generate risk premiums, advises "On the Persistence of Style Returns" (by Stan Beckers of BlackRock and Jolly Ann Thomas at UBS). "More interestingly," they report, "an active style overlay could have added significant value to the market index."
The arbitrage pricing theory (APT), which was developed in the 1970s as an alternative to CAPM, puts no ceiling on the factor possibilities. Empirical tests have only encouraged the intuition that numerous variables influence equity returns. The main challenge is reducing this black hole of possibilities to a short list.
Bringing strategic context to the factor chaos was the inspiration for the Fama-French 3-factor model, which concludes that more than 90% of equity performance is explained by a portfolio's exposure to the large-cap, value and broad market betas. Some argue that's the end of the story. Perhaps, although marginal opportunities are forever popular in finance.
In broad terms, factors can be divided up into three main groups: macroeconomic (such as inflation and interest rate factors), fundamental (dividend yield, book-to-market ratio, etc.), and statistical (relationships identified in the historical record that are expected to generate excess returns). The formal case for using one or more factors in concert with a broad portfolio dates back to 1973, when Robert Merton introduced a theory that married CAPM with dynamic asset allocation.
Merton's model ("An intertemporal capital asset pricing model," published in Econometrica) was more or less ignored at the time. But the notion of managing a portfolio that's diversified across several factors has enjoyed a renaissance in recent years. That's no surprise since the practical limits on implementing a multifactor strategy have given way with the rise of ETFs. Academic support has expanded as well over the years. Proponents of factor allocation point to several decades of mounting evidence that a) asset returns aren't random after all; b) multiple sources of priced risk drive equity performance; and c) some betas exhibit a degree of predictability.
The theoretical framework and supporting empirical research for cutting up the market into multiple betas is well established as the second decade of the 21st century dawns. What's been missing is an expanded set of investment products that cleanly capture more than a handful of the known factors. This last missing piece of the puzzle is finally arriving.
The choice of factor index funds and ETFs is still limited, but hints of things to come can be found in recent launches of momentum and volatility products. There are also new benchmarks, which encourage expectations that product innovation is poised to accelerate. In 2009, MSCI Barra introduced a suite of investable factor indices. A rival set of factor indices was rolled out last year in a joint venture of Russell Investments and Axioma.
Among the catalysts for the new indices is the growing use of factor models, says Rolf Agather, director of index research at Russell. "As investors become more sophisticated, they're using risk factor models to have a better understanding of their risk exposures." Elevating risk management to a high priority, in other words, is the new new thing. "Many investors are realizing that using a traditional framework built around countries, sectors or styles doesn't always provide the insights for appropriately managing risk," he explained in an e-mail. "Investors are looking for new ways to manage their risks more directly."
It's not hard to understand why. Dividing the equity pie into a finer measure of factors can boost the power and control of risk management techniques. In turn, that improves the odds of earning higher risk-adjusted returns. Modern finance has been advocating no less for decades. Just as there's more opportunity in breaking up a global equity portfolio into, say, several regional components, the concept holds true if we define equities (and other asset classes) in a more granular fashion.
This is less about trying to identify factor winners and losers per se, although that surely inspires some of this work. But for strategic-minded investing, the goal is expanding asset allocation options with a broader mix of semi-independent return streams.
As an example, consider how the five Russell Axioma equity factor benchmarks compare with their aggregated source: the Russell 3000, a broad measure of the stock market. The Russell 3000 can be thought of as a passive strategy that holds all the equity factors under one roof. The Russell Axioma indexes, by contrast, separate the broad market beta into five factors that are considered key drivers of market volatility, Agather says (see definitions in Figure 1).
Performance-wise, Figure 3 compares the five against the broad stock market. Factor indexes delivered a range of returns that varied considerably during the four years through the end of 2010 relative to equities generally. That includes a mild correction for the five factors in 2008 as opposed to the steep calendar-year loss in U.S. stocks overall.
A casual review of Figure 3 suggests that the five factor indexes move with a fair amount of independence from the broad market. Correlation analysis confirms the visual intuition. As Table B shows, correlations between the Russell 3000 and the factors run the gamut. No less is true for correlations between the factor benchmarks.
What's The Catch?
Factor indexing harbors much potential for portfolio design, but at a price. Higher expenses vs. conventional indexing and asset allocation may be a problem. Other possible pitfalls: increased complexity and a steep learning curve.
The broad issue is deciding if factor indexing will be worthwhile in the long haul. Yes, according to a growing number of investors, index vendors and fund companies. But not everyone is promoting this bandwagon.
"I'm not convinced that [factor allocation] belongs in investors' portfolios," says Rodney Sullivan, editor of the CFA Institute's Financial Analysts Journal. "I'm a little concerned about slicing this thing too narrowly." He adds that there's still much that's unknown about risk factors as real-world investments. That includes questions about how to intelligently weight factors that have no obvious link to conventionally defined market values. "How you use them in an overall portfolio context is unclear." That's partly because it's not always obvious what's driving the factors, he counsels.
Cautious or not, more factor ETFs are coming, Sullivan concedes. "I expect there'll be an ETF on the so-called minimum-variance portfolio," for instance. That's a strategy that weights stocks based on variance: Shares with low volatility receive higher weights. Why? Because of research that shows that low-vol stocks tend to perform as well if not better than high-vol stocks-yet another CAPM contradiction.
The failure (or perceived failure) of conventional strategies in late-2008 only strengthens the case for factor allocation. But in the rush to embrace a new world order, some decidedly old-fashioned rules still apply. One is the standard caveat that the average investor must hold the market portfolio. That implies that you'll need more than a little confidence (and skill) to rationalize radical surgery on the market's allocation.
Even those who pass this hurdle still face the complications (and higher expenses?) of factor allocation through time. Indeed, factors aren't equally endowed with market-beating properties (or even positive expected returns) in the long run. "The effectiveness of these factors waxes and wanes over time," Sullivan warns. No less awaits the broad spectrum of results with active factor allocation strategies.
James Picerno is editor of The Beta Investment Report and author of Dynamic Asset Allocation (Bloomberg Press).