So you’ve read all about the benefits of index investing. Your portfolio is dirt cheap and broadly diversified. Heck, you’ve even stopped checking your portfolio value on a daily basis. Just when you thought you had it all figured out, ETF providers drop a bombshell by claiming there may be a smarter way to invest.
Traditional index investing is clearly not dumb, but it can sometimes feel that way. There’s a lot of academic research out there that has shown certain risk factors have historically generated higher returns than the market. By tilting towards any of these factors in your portfolio, you have the potential for market beating returns. Even better, by combining a number of these factors into your portfolio, you may enjoy a smoother ride in your pursuit of outperformance.
Based on this idea, iShares has created three multifactor equity ETFs (Canada, US and International), which follow the MSCI Diversified Multi-Factor Indexes. Instead of tilting towards a single factor, these indices combine four well-researched factors: value, momentum, size and quality. Let’s start by taking a closer look at the Canadian version. I’ll look at the US and international multifactor indexes in my next blog.
iShares Edge MSCI Multifactor Canada Index ETF (XFC)
With a management fee of 0.45%, you’ll pay 9 times more to hold the iShares Edge MSCI Multifactor Canada Index ETF (XFC), compared to its plain-vanilla counterpart, the iShares Core S&P/TSX Capped Composite Index ETF (XIC). You’ll also reduce your stock holdings by a third, from 240 companies to 81 companies.
Tracking error to the index is always an issue with any active strategy (and yes, factor investing is arguably an active strategy). One behavioural issue I’ve found with factor investing is the tendency to constantly compare your returns to the index. If your investment strategy strays too far below the index returns, you may be tempted to abandon it. By combining factors together into a single fund, it may help reduce the tracking error of the fund relative to the index (and help investors avoid making any knee-jerk reactions).
If we calculate the monthly tracking error of the single and multiple-factor MSCI indices relative to the MSCI Canada IMI Index (“the market”), we find that the MSCI Canada IMI Select Diversified Multiple-Factor Index tracking error is similar or lower than nearly all of the individual factor indices (with the exception of the quality index).
Monthly Tracking Error to Index: January 1999 to December 2015
Sources: MSCI, Dimensional Returns 2.0
Performance Summary: January 1999 to December 2015
No factor discussion would be complete without a regression analysis. I know that most of my blog readers hate these things. But the fact is, this statistical technique is the best way to measure whether a factor-based index is behaving the way you would expect.
In the tables below, I’ve compared the regression results for a broad-market index with those of the multiple-factor index. For each factor (size, value, momentum, quality) the amounts for the multiple-factor index should be higher than the broad-market index—this indicates the factor tilt. In this analysis, “alpha” represents the portion of the returns explained by something other than that factor tilt. So if the multi-factor strategy performs as expected, you should expect an alpha of zero.
Although the Canadian multiple-factor index had significant tilts towards momentum (+0.07), quality (+0.07) and size (+0.21), it had a negative tilt toward value (-0.03). That’s hard to explain. Also, since size was its biggest factor tilt, I would have expected to see outperformance of smaller companies over the measurement period. But if we review the index performance in the chart above, we find that smaller companies returned about 7.06%, while the market returned 7.24% (whoops).
Things get even more confusing. The unexplained alpha over the period was a whopping 2.41% per year. These results make me question whether there is something else driving the back-tested multiple-factor outperformance – if this is the case, investors may not be receiving a true multiple-factor Canadian equity ETF.
5-Factor Regression Results: January 1999 to December 2015
*Data shaded in light grey have a t-stat greater than 2, which indicates a statistically significant result Sources: MSCI, AQR Data Library