How to pursue a multifactor investment approach

The same theory implies that when comparing two stocks with the same relative price; the one with the higher expected cash flows for that same price has a higher expected return.

And extending the idea further, more profitable companies and companies that do not need to grow their assets as aggressively tend to deliver more cash flows to shareholders. Therefore, we should also expect such stocks to outperform, all else being equal.

Another consideration when selecting a premium is that it should withstand slight variations in how it is defined, as well as working across different sectors, regions and time periods. And it should add to the premiums we already know about, not be a redundant repackaging.

For example, research shows that one proposed premium, 'quality', is simply profitability in a highly convoluted disguise, while another, 'low volatility', adds nothing on top of size, value, profitability and asset growth.

Lastly, a premium must be helpful to investors in the real world. This means we can design a portfolio to capture it or use it as an enhancement on top of other premiums.

Momentum, for instance, is strong in data but requires a high portfolio turnover that erodes performance through high trading costs.

Momentum has its uses, however, as an additional signal when buying and selling stocks in the pursuit of the size, value and profitability premiums. 

Better together

When done right, multifactor investing can smooth your ride and increase your expected return relative to a single-factor approach. 

Diversifying across factors that complement each other can reduce volatility. Value and profitability, for instance, are excellent complements because they tend to target different market segments and have, therefore, rarely been negative together.

To illustrate how multifactor investing can increase expected returns, we use publicly available data on the returns of developed-market stocks since 1990.

Exhibit 1 shows the stocks’ average monthly returns grouped by size, price-to-book and operating profitability – essentially the table is a breakdown of the main Fama-French premiums (size, value and profitability). 

Among large caps on the left, you can see in the differences between the numbers in vertical columns that value outperforms growth.

Comparing horizontal rows, you see that high profitability outperforms low profitability.

The diagonal spreads illustrate that high-profitability value outperforms low-profitability growth by even more.

The same is true among small caps on the right but with even larger magnitudes because of the addition of the size premium.

The bottom-right corner of profitable small-cap-value stocks outperforms all other groups (1.03 per cent return a month).

Exhibit 1. Interacting Premiums 

The implication from these diagonal spreads is that allowing for the interactions between factors into a portfolio’s design is essential.