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Multifactor investing traces its roots to the academic research of Nobel laureate Eugene Fama and renowned researcher Kenneth French*, among others. Their premise is simple: no single factor could sufficiently explain the cross-section of expected stock returns.

Dimensional Fund Advisors, in turn, leveraged this academic research in their approach to factor-based investing, seeking to identify and isolate those equity characteristics that are true drivers of long-term performance. They have identified four factors, or dimensions: overall market, company size, relative price and profitability.

 

Factors that matter

image of the four factors together drive expected return: market, size, relative price and profitability
1 Relative price, as measured by the price-to-book ratio; value stocks are those with lower price-to-book ratios.
2 Profitability is a measure of current profitability, based on the information from individuals companies’ income statements.
Diversification does not guarantee a profit or eliminate the risk of loss.

Let’s take a closer look at each factor:

Overall market. The market dimension reflects the excess return over the risk-free rate that market participants demand for investing in a broadly diversified portfolio of equity securities without any style or market-cap bias. This premium is called the equity premium.

Company size. The company size dimension reflects the excess return that investors demand for investing in small-cap stocks relative to large-cap stocks. The premium associated with this dimension is the small-cap premium.

Relative price. The relative price dimension reflects the excess return that investors expect from investing in low relative price or value stocks (as measured, for instance, by the price-to-book ratio) relative to high relative price or growth stocks. The premium associated with this dimension is the value premium.

Profitability. The profitability dimension provides a way to discern the expected returns of companies with similar price-driven characteristics. For example, if two companies trade at the same relative price, the one with higher profitability should have a higher expected return. The premium associated with this dimension is the profitability premium.

 

Taking asset allocation to the next level

In the past, asset allocation was relatively simple for investors. Decide how to split money between fixed income and equities, and decide whether to invest in index funds, conventional active funds or individual securities. Today, we have the opportunity for more choices by taking into account:

  • additional factors that help explain returns in the equity markets,
  • how those factors interact with each other, and
  • how much emphasis to place on each factor.


Multifactor is a powerful diversifier

This multifactor, or multidimensional, approach requires a higher degree of expertise to evaluate and manage the trade-offs between expected returns, risks and costs. However, this multifactor approach increases the likelihood of capturing the premiums associated with each dimension. And history has shown that a multifactor approach tends to yield improved outcomes for investors.

Image of Chart that demonstrates how multifactor approach performs top quartile over time against benchmarks and single factors.
This chart is for illustrative purposes only and does not represent the performance of any Manulife ETF. Morningstar, as of 12/31/16. Callan chart is from 2002 to 2016. Size is represented by the Russell 1000 Size Factor Index, which tracks the performance of stocks displaying smaller-size characteristics. Value is represented by the Russell 1000 Value Factor Index, which tracks the performance of stocks displaying lower valuation characteristics. Volatility is represented by the Russell 1000 Volatility Factor Index, which tracks the performance of stocks displaying lower volatility characteristics. Quality is represented by the Russell 1000 Quality Factor Index, which tracks the performance of stocks displaying higher-quality characteristics. Momentum is represented by the Russell 1000 Momentum Factor Index, which tracks the performance of stocks displaying momentum characteristics. Multifactor is represented by the Russell 1000 Comprehensive Factor Index, which combines the performance of all five Russell 1000 factor indexes: size, value, quality, momentum, and volatility. Annual return sare based on calendar years. Indexes are unmanaged and do not take transaction costs or fees into consideration. It is not possible to invest directly in an index. Performance figures assume reinvestment of dividends and capital gains. Certain returns shown may reflect hypothetical historical performance. All performance presented prior to the index inception date is backtested performance. The backtested calculations are based on the same methodology that was in effect when the index was officially launched. However, backtested data may reflect the application of the index methodology with the benefit of hindsight, and the historical calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index. Past performance does not guarantee future results.

Learn more about Dimensional Fund Advisors’ expertise

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