Multi-Factor Investing: Strategies, Combinations, and Performance Analysis

8 min readAug 30, 2024

In the dynamic world of investment strategies, multi-factor investing has emerged as a powerful approach to potentially enhance returns and manage risk. By combining different investment factors, investors aim to achieve better performance than single-factor strategies. However, the effectiveness of these combinations can vary significantly. Let’s dive into the world of multi-factor investing, exploring different strategies and analyzing their performance.

Correlation matrix showing the relationships between various factors’ excess returns, calculated on a rolling 3-year basis, compared to the NIFTY50 benchmark

Understanding Multi-Factor Strategies

Multi-factor investing involves combining multiple investment factors to create a more robust portfolio. There are three main types of multi-factor strategies:

1. Double Sort: This strategy involves ranking stocks based on two factors simultaneously. For example, selecting stocks that score high on both value and momentum factors.

2. Combination: This approach creates separate portfolios for each factor and then combines them into a single portfolio. For instance, allocating 50% to a value portfolio and 50% to a momentum portfolio.

3. BarBell: This strategy involves combining two factors that often have low or negative correlation to achieve better risk-adjusted returns. For example, combining high-volatility momentum stocks with low-volatility stocks.

In this analysis, we’ll focus on the BarBell approach, examining four different factor combinations.

Key Metrics for Evaluation

While we’ll present all relevant metrics, two stand out as particularly important for evaluating the effectiveness of multi-factor strategies:

1. Outperformance %: This metric indicates how often the strategy outperforms the benchmark.
2. Bottom 25% ile: This shows the strategy’s performance in the worst quartile, indicating its downside protection.

Other metrics we’ll consider include:

- CAGR (Compound Annual Growth Rate)
- 3-year Rolling Return
- Max Drawdown
- Volatility
- Sharpe Ratio

Let’s examine four factor combinations using these metrics:

Please Note that all the returns calculated for excess returns are 3 year rolling returns and not point to point returns , thereby eliminating the starting point and ending point bias

Momentum & Quality Equi weighted Strategy

Low Volatility + Momentum : The Best

- Strategy: N200_M30 + N100_L30 (BarBell)
- Correlation Coefficient: -0.06

| Metric | Low-Volatility | MoMentum | Combo |
| — — — — | — — — — — — — | — — — — — — | — — — — |
| CAGR | 27.53% | 32.70% | 30.42% |
| 3 yr Rolling Return | 15.50% | 17.99% | 16.81% |
| Max DrawDown | -48.65% | -67.69% | -60.09% |
| Volatility | 17.34% | 22.78% | 19.73% |
| Sharpe Ratio | 159% | 144% | 154% |
| Outperformance | 80% | 86% | 94% |
| Bottom 25% ile | 0.54% | 2.06% | 2.48% |

Distribution of excess returns of BarBell strategy of Momentum & Low Volatility

Quality + Momentum: The Standout Performer

- Strategy: N200_Q30 + N200_M30 (BarBell)
- Correlation Coefficient: -0.21

| Metric | Momentum | Quality | Combo |
| — — — — | — — — — — | — — — — -| — — — -|
| CAGR | 32.70% | 29.13% | 31.06% |
| 3-yr Rolling Return | 17.99% | 17.03% | 17.46% |
| Max Drawdown | -67.69% | -55.57% | -62.44% |
| Volatility | 22.78% | 18.36% | 20.10% |
| Sharpe Ratio | 144% | 159% | 155% |
| Outperformance | 86% | 73% | 93% |
| Bottom 25% ile | 2.06% | -0.14% | 2.57% |

Excess returns distribution (over NIFTY50) of Momentum & Quality Strategy in last 16 years

Excess returns distribution (over NIFTY50) of Momentum Factor alone in last 16 years

Excess returns distribution (over NIFTY50) of Quality Factor alone in last 16 years

The Quality + Momentum combination is the clear winner. With an impressive 93% outperformance rate and a positive bottom 25% ile of 2.57%, this strategy demonstrates both consistent outperformance and strong downside protection. It also maintains a high CAGR and Sharpe ratio, indicating strong overall performance.

Low Volatility + Alpha: A Solid Contender

Alpha & Low Volatility Equi weighted Strategy

- Strategy: N_A50 + N100_L30 (BarBell)
- Correlation Coefficient: -0.21

| Metric | Low Vol | Alpha | Combo |
| — — — — | — — — — -| — — — -| — — — -|
| CAGR | 27.53% | 32.20% | 30.11% |
| 3-yr Rolling Return | 15.50% | 17.61% | 16.45% |
| Max Drawdown | -48.65% | -78.88% | -67.03% |
| Volatility | 17.34% | 25.00% | 20.24% |
| Sharpe Ratio | 159% | 129% | 149% |
| Outperformance | 80% | 74% | 76% |
| Bottom 25% ile | 0.54% | -0.38% | 0.24% |

Excess returns distribution (over NIFTY50) of Alpha & Low Volatility Strategy in last 16 years

Excess returns distribution (over NIFTY50) of Alpha Factor alone in last 16 years

Excess returns distribution (over NIFTY50) of Low Volatility Factor alone in last 16 years

The Low Volatility + Alpha combination also shows promise. While its outperformance rate is lower than Quality + Momentum, it still maintains a solid 76%. The positive bottom 25% ile of 0.24% indicates good downside protection. This combination also achieves a high Sharpe ratio, suggesting good risk-adjusted returns.

Value + Momentum: Mixed Results

- Strategy: N200_V30 + N200_M30 (BarBell)
- Correlation Coefficient: -0.21

| Metric | Momentum | Value | Combo |
| — — — — | — — — — — | — — — -| — — — -|
| CAGR | 32.70% | 26.80% | 30.14% |
| 3-yr Rolling Return | 17.99% | 14.85% | 16.57% |
| Max Drawdown | -67.69% | -63.09% | -64.48% |
| Volatility | 22.78% | 26.85% | 23.45% |
| Sharpe Ratio | 144% | 100% | 129% |
| Outperformance | 86% | 50% | 80% |
| Bottom 25% ile | 2.06% | -6.44% | 1.27% |

Excess returns distribution (over NIFTY50) of Momentum & Value Strategy in last 16 years

Excess returns distribution (over NIFTY50) of Value Factor alone in last 16 years

The Value + Momentum combination shows that Value acts as a drag on performance. While the combo outperforms Value alone, it underperforms pure Momentum in both key metrics. However, it does show some improvement in the Sharpe ratio compared to Value alone.

Value + Alpha: Underwhelming Performance

- Strategy: N200_V30 + N100_A30 (BarBell)
- Correlation Coefficient: -0.46

| Metric | Alpha | Value | Combo |
| — — — — | — — — -| — — — -| — — — -|
| CAGR | 27.82% | 26.80% | 27.32% |
| 3-yr Rolling Return | 14.33% | 14.85% | 14.25% |
| Max Drawdown | -72.85% | -63.09% | -68.55% |
| Volatility | 22.57% | 26.85% | 23.51% |
| Sharpe Ratio | 123% | 100% | 116% |
| Outperformance | 73% | 50% | 66% |
| Bottom 25% ile | -0.73% | -6.44% | -1.67% |

Excess returns distribution (over NIFTY50) of Alpha & Value Strategy in last 16 years

The Value + Alpha combination demonstrates the poorest performance among the four. The outperformance rate is the lowest at 66%, and it’s the only combination with a negative bottom 25% ile, indicating poor downside protection. While it shows some improvement over Value alone, the overall performance is underwhelming compared to other combinations.

Key Insights

1. Quality + Momentum Reigns Supreme: This combination shows the highest outperformance rate and the best downside protection, making it the most attractive option. It also maintains strong performance across other metrics.

2. Low Volatility + Alpha Shows Promise: While not as strong as Quality + Momentum, this combination offers solid performance and good downside protection, with a particularly strong Sharpe ratio.

3. Value as a Drag: In both combinations involving Value (with Momentum and Alpha), the Value factor appears to drag down performance. The combined strategies underperform their non-Value counterparts.

4. Momentum’s Strength: Momentum appears as a strong factor in multiple combinations, contributing to high outperformance rates and generally good performance across metrics.

5. Importance of Factor Selection: The significant performance differences between combinations underscore the critical nature of factor selection in multi-factor investing.

6. Risk-Return Trade-offs: While we focused on outperformance and downside protection, the other metrics reveal interesting trade-offs. For instance, Low Volatility + Alpha has a lower CAGR than Quality + Momentum but also lower volatility.

Conclusion

Our analysis reveals that not all factor combinations in multi-factor investing strategies are equally effective. The Quality + Momentum combination stands out as the clear winner, offering both high outperformance and strong downside protection, along with solid performance across other metrics.

The Low Volatility + Alpha combination also shows promise, particularly for investors prioritizing risk-adjusted returns. Conversely, strategies involving the Value factor appear to underperform, suggesting that investors should be cautious when incorporating Value into their multi-factor approaches.

These findings highlight the importance of careful factor selection and combination in multi-factor investing. While the BarBell approach demonstrated here can be effective, investors should also consider other multi-factor strategies like Double Sort or Combination, depending on their specific investment goals and market views.

As always, it’s crucial to conduct thorough research and consider your specific investment goals and risk tolerance before implementing any investment strategy. The world of multi-factor investing offers exciting possibilities, but it requires a discerning eye to identify the truly winning combinations.

Watch detailed YouTube video here : https://youtu.be/7YfWs8Vzmk4?si=l-wOt0yAlMLgLePT