Multi-factor funds explained: Are they the right fit for your portfolio?

Representative image

Multi-factor funds are gaining the attention of investors looking for a more considerate equity investment strategy. By taking a number of different market factors and marrying them into one investment, these funds aim to deliver a mix of risk and reward that no single factor strategy can. Here's what you need to know before you determine whether they belong in your landscape.

What are multi-factor funds?

Multi-factor funds are value mutual funds or exchange-traded funds (ETFs) that select stocks from a combination of factors such as value, quality, momentum, low volatility, and size. Each factor is a distinctive characteristic believed to create long-term returns. Instead of employing a single factor, these funds blend several, with the notion of smoothing performance across different market cycles.

How they work in practice

Fund managers or index providers use rules-based approach to screen and weight stocks on a number of factors. A multi-factor strategy, for example, might prefer low-debt firms (quality), which are trading at discounted fair prices (value), and having increasing price trends (momentum). By blending factors, the fund seeks to exploit multiple drivers of returns with lower chances of being out of favour for a prolonged period with one factor.

Possible benefits for investors

The main advantage is diversification — not just between industries or companies, but between style of investing. This can reduce volatility and give more consistent returns over the long run. Multi-factor funds also have a rules-based, systematic process, which can keep emotional decision-making to a minimum and help investors stay disciplined.

Risks and considerations

While multi-factor funds are designed to be more resilient, they are still exposed to equity market risks. Well-performing factor combinations in one period might lag behind in another. Expenses will be slightly greater than for single-factor or plain index funds, especially for actively managed multi-factor offerings. Investors shouldn't lose sight that these funds don't aim to beat the market each year — their allure is in long-term coherence.

Who should use them

They can work for investors who already possess a core equity portfolio and want to add to it with a strategic, factor-based component for diversification. Multi-factor funds are optimal for investors with a medium- to long-term time horizon and who are comfortable assuming equity risk but don't wish to be wedded to one type of market.

FAQs

Q. What is the difference between multi-factor funds and index funds?

Index funds imitate a broad market index without screening on some factors, while multi-factor funds selectively choose and weight stocks based on pre-defined characteristics like value, momentum, and quality.

Q. Do multi-factor funds guarantee lower risk?

No. They attempt to reduce volatility through factor diversification but remain subject to market downturns and may lag from time to time.

Q. Are multi-factor funds suitable for novices?

They can be invested in by beginners, but first a diversified core portfolio of broadly based equity or index funds should be invested in before investing in specialized techniques such as multi-factor funds.