Factor Primer Series: Multifactor

February 13, 2020

All good things must come to an end, and this piece concludes our series on factor investing (What is a Factor?; Small-Cap; Value; Momentum; Profitability).  Here we’ll look at bringing all the factors together, in what we will refer to as multifactor investing. As a reminder, we have defined factors as a source of excess return that is sensible, persistent over long time periods, pervasive across markets, and cost-effective to capture throughout this series. Multifactor investing is simply combining more than one factor in a portfolio.

History of Factor Investing

Using factors to explain returns can be traced back at least as far as 1976 and Stephen Ross’ paper on arbitrage pricing theory, which in broad strokes argued that the expected return of an asset could be derived where an asset’s sensitivity to various factors represent its price.1 Investors and theorists continued to build on this idea, which lead to Eugene Fama and Ken French’s seminal 1993 paper which created a multifactor model looking to small-cap and value stocks as a driver of excess returns.2 Over time, more and more factors were identified (some additive, some not), and more and more investors wanted access to portfolios made up of these factors.

Why does Multifactor Investing Work?

The key is diversification. Factors are diversifying against each other, which helps smooth the ride. As you can see in the below chart that outlines the correlation of excess returns (defined as returns above the S&P 500), the various factors move in different directions at different times. A correlation of 1 means that the excess returns move in the same direction, and a negative 1 means they move in opposite directions. The correlations below are all relatively low or negative amongst the factors.

This diversification works. A multifactor portfolio generated the highest return over the last 20 years versus not only the market but higher than even the best of the four factors shown.  Over this stretch of time, multifactor outperformed the S&P 500 by over 1.75% annualized.  That improves outcomes substantially.

Over the long term, multifactor investing wins and wins big. It seems simple, but as we know, simple doesn’t mean easy.    The nature of the markets means while it wins over the long term, it doesn’t win every year. In fact, multifactor has outperformed the S&P 500 in 13 of the last 20 years, leaving 7 years where the S&P 500 outperformed. Successful investors always should focus on long-term performance, as attempting to time the market has proven nearly impossible even for the brightest investment minds.


As we bring our overview of factor investing to a close, we can summarize our journey as such. Factors have led to better outcomes over time and have academic research behind them supporting their reason for existence.  Just like it makes sense to have different types of assets in your portfolio like stocks and bonds, it makes sense to have multiple factors in there as well.  Over long-term investment horizons, factors each generate excess returns compared to the market, yet become even more powerful when combined together. BDF has been utilizing factors for years and continues to keep an eye out as more research continues to evolve the field of factors.

1Ross, Stephen (1976). “The arbitrage theory of capital asset pricing”. Journal of Economic Theory13 (3)
2 Fame, Eugene F.; French, Ken R., “The Cross-Section of Expected Stock Returns,” Journal of Finance, Volume 47, June 1992.

Disclosures: Past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk.  Future performance of any investment or wealth management strategy, including those recommended by Balasa Dinverno Foltz LLC (BDF), may not be profitable, suitable for you, prove successful or equal historical indices.  Historical indices do not reflect the deduction of transaction, custodial or investment management fees, which would diminish results.  Any historical index performance figures are for comparison purposes only and client account holdings will not directly correspond to any such data.  BDF clients must, in writing, advise BDF of personal, financial or investment objective changes and any restrictions desired on BDF’s services so that BDF may re-evaluate its previous recommendations and adjust its investment advisory services.  BDF’s current written disclosure statement discussing advisory services and fees is available for review at www.BDFLLC.com or upon request.

Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from BDF.

MultifactorMultifactor is represented by the MSCI USA Diversified Multifactor Index. The MSCI USA Diversified Multiple-Factor Index is based on a traditional market cap-weighted parent index, the MSCI USA Index, which includes US large and mid-cap stocks. The index aims to maximize exposure to four factors – Value, Momentum, Quality and Low Size while maintaining a risk profile similar to that of the underlying parent index.

Momentum –  Momentum is represented by the MSCI USA Momentum Index. The MSCI USA Momentum Index is based on MSCI USA Index, its parent index, which captures large and mid-cap stocks of the US market. It is designed to reflect the performance of an equity momentum strategy by emphasizing stocks with high price momentum while maintaining reasonably high trading liquidity, investment capacity and moderate index turnover.

ProfitabilityProfitability is represented by the MSCI USA Quality Index. (MSCI USA Quality NR USD) The MSCI USA Quality Index is based on the MSCI USA Index, its parent index, which includes large and mid-cap stocks in the US equity market. The index aims to capture the performance of quality growth stocks by identifying stocks with high-quality scores based on three main fundamental variables: high return on equity (ROE), stable year-over-year earnings growth and low financial leverage.

ValueValue is represented by the Russell 1000 Value index. (Russell 1000 Value TR USD) The Russell 1000 Value Index measures the performance of value stocks drawn from Russell 1000 index. The complete market capitalization of Russell 1000 index is divided into growth and value segments by using three factors: price to book ratio, forecasted growth and sales per share growth. The index is market-capitalization-weighted.

Small-CapSmall Cap is represented by the Russell 2000 index. The Russell 2000 Index® measures the performance of the 2,000 smallest companies in the Russell 3000 Index.

S&P 500 – The S&P 500 Index includes a representative sample of the largest 500 companies in the U.S.

Excess Return – Excess return in the context of the correlation matrix is defined as the return of the various factors in excess of the benchmark, in this case, the S&P 500 index. The S&P 500 Index includes a representative sample of the largest 500 companies in the U.S.