An Examination of Different Approaches to Factor Combination (Part 1)

Two primary approaches on combining factors: isolated and integrated

Adam McCullough, CFA 19 May, 2017 | 17:16
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First came single-factor exchange-traded funds. These funds targeted individual factors associated with attractive long-term risk-adjusted returns. While many have become comfortable with the underpinnings of factors like value and momentum and how investors try to harness them in practice, it can be difficult to understand how to combine individual factor funds. More recently, fund providers have launched a bevy of multifactor funds that offer investors prepackaged factor combinations. Why might an investor opt for a fund that fuses factors together on their behalf? Can this approach add value relative to a do-it-yourself approach of mixing single-factor funds? And what is the best approach to combining factors in a multi­factor framework? I’ll set out to answer these questions here.

The case for diversification extends to factor investing. The article “The Case for Multifactor ETFs,” details the benefits of spreading one’s factor bets. Individual factors can underperform their factor peers and the broader market for prolonged periods of time. Combining factors with low correlations to one another will yield a more stable risk/return proposition relative to owning any one factor-focused fund in isolation. This may also yield all-important behavioral benefits. A smoother ride may help investors to stay the course when a particular factor experiences a dry spell. But factor diversification is easier said than done. When it comes to selecting multifactor funds, there are several decisions to consider:

  1. Which factors are in the mix?
  2. How are the fund’s factor exposures measured and constructed?
  3. How are weightings assigned to each factor?
  4. How are these factors combined?


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About Author

Adam McCullough, CFA  Adam McCullough, CFA, is an Analyst on Morningstar’s Manager Research Team, covering passive strategies.

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