Why multi-factor funds are smarter beta

Smart beta is getting smarter. In the process of growing more esoteric, and possibly its marketability to retail investors. It may, however, be putting itself on a firmer footing when it comes to claims that it can beat the market in the longer term.

For the uninitiated, smart beta is the catch-all term for rules-driven quantitative strategies that take major indices and reweight them so as to create a better chance of beating the market in the long term - if all goes well. They cost more than a standard passive (or "beta") fund, but not much more, and the hope is that they can beat the benchmark by a little more than the difference in fees.

Typical strategies include weighting towards value (cheap) stocks, or stocks with momentum, or stocks with high dividends or low volatility.

The greatest problem with the concept is that if it is successful, it should carry the seeds of its own demise. Once investors have cottoned on that cheap stocks outperform, more will buy them and the anomaly will disappear. The same is true of other anomalies. Put even more simply - eventually you will run out of the greater fools prepared to buy what you are selling and sell what you are buying.

Further, even as these factors should logically lose their power in the longer run, there is also the problem that they tend to be cyclical. The value effect, for example, is strong and has been observed over many decades. But value investors have suffered significant underperformance for the rally of the last five years, just as they did at the top of the bull market in the late 1990s. Similarly momentum usually works beautifully, but occasionally crashes.

The new answer is to create multi-factor funds. Combine several factors into one fund, and you will always have the dominant factor of the moment pulling you through. And you might just have reached the holy grail of the fund that stays ahead of the market all the time.

How do they do it? Two recent offerings use different approaches. Global X is launching a fund that combines four different factors in an index designed by the Edhec-Risk Institute. The "Scientific Beta" indices combine four factors - value, size (small stocks do well), low volatility and momentum.

It takes an underlying index, and constructs four different indices from it. For example, the value index includes only those that show up as cheapest. It then allocates weightings to each of these subindexes. Over time, some will do better than others, and so there is periodic rebalancing. This can happen once a quarter, but in historic back tests rarely happens more than once a year (to limit turnover). This rebalancing can be tweaked to take advantage of factors' cyclicality. If Edhec's algorithm sees that the parent index is being driven by one particular factor - for example, value - then it will overweight value slightly.

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BlackRock's iShares, the giant of the ETF market, also has a multi-factor offering, known as FactorSelect ETFs, and based on indices produced by MSCI. Like Global X, their funds use four factors, but substitute "quality" (a measure of balance street strength) for low-volatility. Their method for blending the factors together, however, is very different.

For each factor, they take the base index and rank it. The cheapest stock will score 1 for value, while the most expensive will get the highest rank, and so on. After producing four scores, they are then added together. The top 25 per cent on this combined ranking then go on to make up the new multi-factor index. This exercise is repeated twice a year.

This is a different approach, more like a traditional quantitative screen. The key difference is that a stock that shows up as very cheap, but is a big company with a poor balance sheet and lousy momentum, will not get into the final index. Under the Global X approach, a stock that ranked high on value would do so.

Both approaches have been backtested, and have succeeded in beating parent indices in the past. In the case of the MSCI ETFs, the all-world version has returned 10.56 per cent per year versus 6.98 per cent for the all-world index itself - although it did underperform slightly during the crash of 2008.

This activity has several implications. Exchange traded funds have until now largely been used as vehicles for investors (or usually investment advisers charging for the service) to do their own asset allocation.

This is an attempt to do something different and offer a new and improved version of a "total market" fund - possibly even a better mousetrap. Jack Bogle, the founder of Vanguard, who largely created the modern passive indexing business, says that a total market index, which buys all the stocks on offer, is all an investor needs, and that it is arrogance to try to beat it. These new multi-factor funds are effectively accepting his challenge. Both offerings aspire to give you the one fund you should ever need. Time will tell if this is hubris.

Second, simplicity has been left behind a while ago. These funds are fascinating, and deserve to be watched closely. But explaining what they do is difficult (as I can attest having just tried to do so). When it comes to finding a market for them, that could be a problem.

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