Multi-factor investing that combines value, momentum, quality (profitability), or low volatility factors is today’s hot new investment approach. There has been an explosion of multi-factor ETFs recently with eleven of the sixteen existing U.S. multi-factor funds coming to market this year and five of them showing up within the past 60 days.
But multi-factor funds can have some quirks and issues. If the large variety of factors is a “factor zoo,” then multi-factor approaches are a “factor circus” with its own collection of silly clowns, dangerous acrobats, and amusing jugglers disguising multi-signal factor biases [1].
Factor Investing Issues
With factor investing, in general, there are three problem areas: tractability, scalability, and volatility. Regarding tractability, it is well-known that value investing can have long periods of serious underperformance. This happened in the late 1990s and also somewhat during the past two years. Not all value investors may be willing to see this happen without losing patience and giving up on their factor portfolios. Momentum and other factors are also subject to sustained tracking error.
Scalability has to do with too much money chasing after too few stocks. Factors perform best when you can focus on those stocks having the strongest factor characteristics. For example, van Oord (2015) showed that from 1926 through 2014, only the top decile of U.S. momentum stocks outperformed the market. Stocks below the top decile added nothing to strategy results.
But only two out of the twelve large-cap U.S. equities single factor ETFs include only stocks that are within the top decile of their factor rankings. For example, the oldest and largest single factor value ETFs are iShares S&P 500 Value (IVE), iShares Russell 1000 Value (IWD), and Vanguard Value (VTV). They hold 72%, 69%, and 50% of the stocks that are in their investable universes. This makes them, to a great extent, closet index funds with relatively high fees.
Their large sizes ($8.3 billion, $23.5 billion, and $34.6 billion) may impede them from focusing on just fifty (the top decile of S&P 500 stocks) or one-hundred (the top decile of Russell 1000) value stocks. The same is true with momentum. One of the largest momentum funds, with over $1 billion in assets, is the AQR Large Cap Momentum Style mutual fund with an expense ratio of 0.45. It holds 532 out of an investable universe of 1000 stocks. This is a far cry from the top decile of momentum stocks. AQR manages considerably more than this in the momentum arena through its hedge fund and multi-factor funds. Large amounts of investment capital may make it difficult for single-factor funds to focus only on the small number of stocks that appear in their top factor deciles.
The third problem for single-factor portfolios is increased volatility and large bear market drawdowns that can accompany value, momentum, and small-cap factors. Trend following filters, such as absolute momentum, can help reduce downside exposure in long-term bear markets, but they do little to reduce uncomfortable short-term volatility. Trend following is also less effective when applied to value factors than when applied to other factors like momentum.
Multi-Factor Solutions
All three of these problem areas for single-factor investing – tractability, scalability, and volatility – can be reduced by using intelligently constructed multi-factor portfolios. Multiple factors reduce tracking error since it is unlikely that several factors will substantially underperform at the same time. As for scalability, if a fund uses four factors instead of just one, it can handle four times the investment capital without eroding its ability to enter and exit the markets. Finally, you can sometimes reduce the volatility and bear market drawdowns associated with value and momentum factors by combining these factors with less volatile ones, such as quality and low volatility.
An issue associated with multi-factor funds, however, is their average annual expense ratio of 41 basis points for what are often enhanced index funds. Until recently, an investor who wanted multi-factor exposure would have been better off creating it herself by combining the single factor iShares MSCI USA Value Factor, USA Momentum Factor, USA Quality Factor, and USA Minimum Volatility ETFs, since these all have expense ratios of only 15 basis points.
New Solution
This situation changed last month when Goldman Sachs entered the ETF business with an offering called Goldman Sachs Active Beta U.S. Large Cap Equity (GSLC). It uses the value, momentum, quality, and low volatility factors. Here is a description of how they determine these:
• Value: The value measurement is a composite of three valuation measures, which consist of book value-to-price, sales-to-price and free cash flow-to-price (earnings-to-price ratios are used for financial stocks or where free cash flow data are not available).
• Momentum: The momentum measurement is based on beta- and volatility-adjusted daily returns over an 11-month period ending one month before the rebalancing date.
• Quality: The quality measurement is gross profit divided by total assets or return on equity (ROE) for financial stocks or when gross profit is not available.
• Low Volatility: The volatility measurement is the inverse of the standard deviation of past 12-month daily total stock returns.
Even though the fund holds 432 stocks out of an investable universe of 500, it uses a weighting scheme that allocates more of its capital to stocks with high factor ratings. GSLC rebalances positions quarterly and uses a turnover minimization technique (especially useful for momentum stocks) of buffer zones to reduce the number of portfolio transactions.
The fund came into existence because some of Goldman’s largest clients wanted to invest using an ETF wrapper to reduce their tax consequences. Because of this sponsorship, the fund was set up with an annual expense ratio of only 9 basis points.[2] This is the same expense ratio as the biggest and most popular ETF in the world, the SPDR S&P 500 ETF Trust (SPY). GSLC already has $78 million invested in it since coming to market one month ago.
GSLC does not have a trend following filter like absolute momentum to help it avoid severe bear market drawdown. GSLC is also unable to enjoy international diversification during those times when international stocks show greater relative strength than U.S. stocks. Its future performance also may not be as good as expected, since, like most other factor ETFs, GSLC relies on data mining to determine its factor parameters.
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[1] See Novy-Marx (2015) for details on multi-signal bias issues.
[2] GSLC has an annual fee waiver of 15 basis points until September 14, 2016, after which time it has the option to raise its expense ratio up to 0.24. Whether or not fees are raised often depends on asset growth.
