Is there low-cost outperformance?

MULTI-FACTOR FUNDS: MAY BE A COMPELLING OFFERING

New approaches that look to give investors exposure to other market factors and multi-factor funds have been developed.

Over the last 20 years there’s been a massive uptake of index tracking products globally. According to figures from Deborah Fuhr of ETFGI, over $4 trillion (about R53.6 trillion) is invested in exchange-traded funds globally.

The bulk is held in market cap-weighted equity products: funds that track broad, “vanilla” market indices like the S&P 500, FTSE 100 or MSCI World.

There’s simplicity and ease of use, but these products aren’t unproblematic. EDHED-Risk Institute’s Erik Christiansen points out two major criticisms of market cap-weighted indices. First is the concentration problem – worse in SA than in other markets.

Currently one stock, Naspers, makes up over 17.0% of the FTSE/ JSE All Share Index. The top ten companies together have a weighting of over 50%.

As such, you’re not truly exposed to all 160 stocks in the index. The weightings of the smaller companies are too meagre to have material impact on the index performance.

“Secondly, you also have some unfortunate factor exposures in market cap-weighted indices. By construction you are overweight large-cap companies, and you are also exposed more heavily to growth stocks,” Christiansen notes.

That means you’re tilted away from smaller value stocks, which should, over time, outperform.

Factor investing

This has given rise to new approaches looking to give investors exposure to other market factors. “Smart beta” funds have been developed to focus on value, momentum, quality or low volatility.

These single factor funds are popular and can diversify a portfolio, but aren’t without problems.

“The temptation has been for factor products to try to maximise factor exposures in the search for returns. But often they forget about the basic principles of portfolio construction … diversification and minimising unrewarded risks,” says Christiansen. Single factor funds are often unbalanced. They outperform over the long term, with periods of significant underperformance. “The argument for factors is that you get rewarded in the long term for holding specific risks,” Christiansen explains. “And by definition this means they must be cyclical, because you have to take risk to get a return.” People tend to buy into a single factor or smart beta fund after a period of outperformance, effectively buying high and selling low.

You are exposed more heavily to growth stocks

Multi-factor investing

Recently product providers have developed multi-factor funds. Instead of being exposed to one market risk, like value, they incorporate a number together to create more balanced exposure.

“The returns of many of the established equity factors can be combined to provide more stable excess returns,” S&P Dow Jones Indices noted.