Use factor investing to build a diversified portfolio

Investors have long accepted that the key to portfolio construction is to diversify across asset classes — stocks, bonds and perhaps alternative investments such as hedge funds or commodities — in order to ensure the overall portfolio will stay on course to deliver targeted long-term goals, despite various ups and downs among the portfolio holdings.

The zig in one asset class will, in principle, be balanced by the zag of another asset class.

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The financial crisis of 2007–2009, however, revealed otherwise, as stocks, bonds and alternative investments all moved largely in the same direction at the same time. Since then, investors seeking new ways to manage risks and enhance returns have been looking more closely at implementing factor-investing strategies to diversify their asset allocation and dig deeper into what characteristics make up their portfolio holdings.

Factor investing, which is often accessed through smart beta exchange-traded funds, aims to identify specific factors that may offer excess or differentiated returns when targeted within a strategy. The five factors most widely recognized are size, momentum, low volatility, quality and value.

Factor investing has attracted considerable attention of late, with high-profile investors such as Research Affiliates’ Rob Arnott and AQR’s Cliff Asness waging well-publicized debates in the media over its merits. With the growing interest in this investment methodology among advisors and their clients, it is important to understand what factor-based investing entails and when and how it is appropriate for long-term asset allocations.

To clarify the focus of factor-based strategies, keep in mind an analogy that the investment consultant Eugene Podkaminer once coined: “If asset classes are like complex molecules, factors are the atoms that serve as building blocks.” Rather than seek diversification across asset classes — stocks vs. bonds, for example — factor-based investing aims to diversify across certain basic, objective characteristics that help to explain risk and return, such as value, size and volatility.

“In an uncertain world, the value of diversification remains unchanged. The focus, however, may be shifting from targeting asset classes to identifying and mitigating risk factors.”

For example, stock allocation could be divided between stocks associated with low volatility and stocks associated with high volatility. A portfolio diversified across the basic building block of volatility could then be expected to provide reduced risk while still delivering reasonable or even better investment returns when compared to the market.

The development of factor-based investing is grounded in academic research that began in the 1960s with the Capital Asset Pricing Model, which introduced the relationship between risk and expected returns. This model was among the first to calculate the theoretically appropriate rate of return required for any risky asset to be included in a portfolio. Its central finding was that in order to earn higher returns than those of the market as a whole, investors had to take on higher risk.

Economist Stephen Ross took the research a step further in the 1970s with his Arbitrage Pricing Theory. Often viewed as an alternative to CAPM, APT posits that returns are determined by multiple factors. An asset’s expected rate of return is dependent not only on its risk premium but also on various macroeconomic, market and security-specific factors that have been shown historically to produce excess long-term returns.

As a tactical play, these factors can be used to implement market forecasts, but they may become even more compelling when combined as strategic core holdings. (Of course, over short time horizons, any factor can exhibit cyclicality and underperformance, so investors need to maintain appropriate horizons.)

Market turbulence should reinforce for investors the importance of avoiding a “Goldilocks portfolio” that performs remarkably well in one type of economic scenario. Instead, they might be better served by considering the use of well-studied risk factors to build portfolios that perform reasonably well in multiple scenarios. Each factor can deliver specific, unique benefits — but not in all market environments — which leads to a discussion of how factor strategies fit together into a customized portfolio that can withstand different market cycles.

These factors can include size, momentum, low-volatility, quality and value:

  • The size factor seeks to capture excess returns of smaller companies, as measured by market cap. Smaller companies may grow faster than large companies and the overall economy, and they may offer a return premium due to increased risk and reduced liquidity relative to their larger counterparts. However, this factor can be difficult to capture due to the low trading volume of small-cap stocks.
  • The momentum factor seeks to capitalize on the inefficiencies caused by over- or underreacting to market events. Market reactions are inherently driven by behavior, which can be difficult to predict, but where there is inefficiency, there is often opportunity.
  • The low-volatility factor seeks to participate in the market’s upward movements while potentially protecting against significant downdrafts, leading to a smoother ride for investors. A potential drawback to the low volatility factor is that they are likely to lag broader market performance during strong bull markets.
  • The quality factor seeks to capture the excess return of high-quality companies compared to the market. It looks at a company’s fundamental health, including the strength of its balance sheet, earnings stability and debt level. Quality is subjective in nature, making it challenging to quantify. But intuitively, it makes sense that companies with strong balance sheets and effectively managed debts could make for ideal investment targets.
  • The value factor seeks to capitalize on dislocations in market prices that can occur when companies are priced low relative to their fundamental value. Critics have argued that the evidence in support of the value factor is influenced by data mining.

In an uncertain world, the value of diversification remains unchanged. The focus, however, may be shifting from targeting asset classes to identifying and mitigating risk factors.

Investors may find that these strategies offer interesting opportunities to build portfolios that deliver the same or better returns as the overall market but with less risk. Using factor-based models may then enable investors to build truly diversified portfolios that allow them to achieve their unique investment objectives.

— By Dan Draper, head of Invesco PowerShares

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