The menu of multifactor funds has expanded considerably over the past decade. As the options have grown, so has investors' research burden. These funds are diverse and often among the most-complex index strategies on the market. While many of these strategies may sound similar, there are important differences in their approaches to portfolio construction, which often yield very different portfolios and performance. Most of these funds have disappointed in recent years, illustrating that diversification across factors with strong theoretical support isn't sufficient to guarantee strong performance. Morningstar’s passive strategies research team recently published a paper which provides a closer look at the growing landscape and outlines a framework to evaluate these funds' investment processes. Click here to view the full paper.
Key Takeaways
- The number of multifactor funds has grown considerably over the past decade, though there are signs the market is maturing.
- Multifactor funds' share of the strategic-beta market has held steady at between 4% and 6% for most of the past decade. This small market share is likely due to these funds' complexity and weak performance, which have hindered adoption.
- Most multifactor funds have underperformed their respective Morningstar Category indexes over the trailing three and five years through September 2020.
- Morningstar’s framework for evaluating multifactor funds' approaches to portfolio construction includes several questions worth asking before buying any multifactor fund.
Diversification Benefits
The case for multifactor funds is the case for diversification. Just as it's prudent to diversify across asset classes, sectors, regions, and securities, it's a smart idea to spread bets across multiple factors that each have a good chance of long-term success. Doing so can reduce risk and make it easier to stick with these factors through their inevitable rough patches.
A Growing, But Maturing Landscape
Interest in multifactor funds has grown over the past decade. Assets invested in multifactor index funds grew to $65 billion globally at the end of September 2020, up from $7 billion a decade earlier, as Exhibit 1 shows. Most of these assets were held in U.S.-listed funds, which accounted for $57 billion.
Exhibit 1
This growth rate was similar to that of the broader market for strategic-beta funds. Multifactor funds' share of this market has held has steady at between 4% and 6% for most of the past decade. Multifactor funds enjoyed an estimated $44 billion in net inflows over the past decade. However, flows turned negative over the trailing 12 months through September 2020, during which these funds shed $4.3 billion.
It's a bit surprising that these funds have gained as much traction as single-factor funds, as they are often more suitable as core holdings and take away the challenge of figuring out how to combine factors in a portfolio, which many investors are not well-equipped to tackle. These products' complexity has likely hindered adoption. They often more closely resemble quantitative active strategies than passive index portfolios. As such, investors often wait to see how these funds perform before buying them.
There are many multifactor funds vying for attention. The menu of funds has expanded considerably over the past decade. At the end of September 2020, there were 294 multifactor funds on the market, up from 45 at the end of 2010. Most of these funds haven't been on the market long. Only 79% of the multifactor funds currently on the market were around five years ago.
However, new product growth has slowed in recent years, particularly in the U.S., as the market has become increasingly saturated. Fund closures exceeded launches through the third quarter of 2020, reflecting the saturation of the market, disappointing performance, and asset managers' efforts to shutter smaller funds.
Disappointing Performance
Most multifactor index funds have disappointed in recent years, which may help explain why these funds haven't grown faster than other types of strategic-beta funds. For example, of the 91 multifactor index funds listed in the U.S. at the end of September 2015, only 16% survived and outperformed their respective category benchmarks over the next five years. The funds in that group that survived lagged their category benchmarks by 2.4 percentage points annually on average during that period. The results weren't much better in other regions or over the most recent three-year period, as shown in Exhibit 2.
Exhibit 2
Much of this underperformance is due to the poor performance of value (and small size in the U.S.), which many of these funds lean into. While these funds' inclusion of other factors tended to partially offset this performance drag, it often wasn't enough to overcome it. This demonstrates factor diversification doesn't eliminate the risk of underperformance, even over lengthy periods.
While different multifactor funds may often seem alike, there was considerable dispersion in their performance (and holdings). These funds often differ with respect to the factors they target, how they measure and combine those factors, and how aggressively they pursue them.
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