A framework for analyzing multifactor funds

Six important questions investors should ask before buying a multifactor fund.

Alex Bryan 25 September, 2018 | 5:00PM

Multifactor funds are among the most complex index investments, more closely resembling active than passive management. As such, it is necessary to apply a similar level of rigor to evaluate their portfolio-construction processes. In June, Morningstar's Manager Research team published "A Framework for Analyzing Multifactor Funds." What follows is a summary of that framework, which should help investors assess these funds' approaches to portfolio construction to better navigate the landscape.

What Is the fund's selection universe?

The selection universe, also referred to as a parent index, is the collection of potential stocks that a fund whittles down to build its investment portfolio. This is typically a broad index, like the Russell 1000 Index. The selection universe should serve as a benchmark for the fund's performance. It may also offer insight into the fund's potential to outperform its parent index and/or category peers. For example, the payoff to most investment factors has historically been the greatest among the smallest stocks. This may be because they are more likely to be mispriced than larger stocks. So -- all else being equal -- funds that start with a universe of large- and mid-cap stocks (as most multifactor funds do) likely have less potential to outperform than those that start with an all-cap universe or a group of small-cap stocks.

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About Author

Alex Bryan

Alex Bryan  Alex Bryan, CFA, is director of passive strategies for North America at Morningstar. Before assuming his current role in 2016, he spent four years as an analyst covering equity strategies. He holds an MBA with high honors from the University of Chicago Booth School of Business.