Single factor “smart beta” indicized strategies that were once exclusive to the realm of active management. Multifactor indexing is beginning to garner much interest as the newest chapter of index innovation.
It’s a natural conjecture that if single factors are successful, combining more than one factor should prove even more beneficial. While any combination of two successful factors theoretically offers a diversification benefit, some combinations amount to more than the sum of their parts. The benefit of a combination depends on the risk/return profile of the individual factors and the correlation between them. Even if the risk/return profiles of factor indices are similar, some factor pairings can result in greater diversification benefits by lowering tracking error and raising information ratios. For example, in the illustration of S&P 500 Low Volatility Index and the S&P 500 Momentum Index combination below, any allocation between the two factor indices offers a better risk/return payoff than either index combined with the S&P 500. But while Low Volatility offers a much better risk/return payoff on an absolute basis, a 50/50 blend of the two factor indices yielded a much higher information ratio.
There is more than one way to skin the multi-factor index cat. Rather than simply bolting together single factor indices, screening for stocks that exhibit characteristics of more than one factor is a highly viable alternative approach. This stock level approach will almost certainly provide higher and more balanced factor exposures than simple combinations of the same single factor indices. But combinations of single factor indices have the advantage of simplicity; they offer great flexibility in customizing exposures. One investor might like a 50/50 split between Low Volatility and Momentum; another might prefer to tilt more decisively to one or the other. Combining single factor indices is an efficient way to make that happen.