Factoring Investing, along with Alternative Investment Strategies, true portfolio diversification, Goal Based Investing (Liability Driven Investing), building robust investment portfolios, behavioural economics, and Responsible Investing, will be key themes of future blogs.
I thought this was a good article to cover as the first blog on Factor Investing: The Case For Adding Factors To Your Portfolio.
This is a good article for those new to Factor Investing or at the beginning of considering the addition of factor exposures into a portfolio. There are many articles like this from other provides.
A few of key points from the article:
- A factor can be thought as any characteristic relating a group of securities that is important in explaining their return and risk.
- Factor Investing is not new. It has been around for sometime within the industry, Value and Growth in the old days. The drivers of value and momentum have been recognised by academics and professionals for decades.
What has changed, particularly over the last 5 years, is the technology that makes it easier and cheaper to capture market factors.
- There are not that many rewarding factors, Value, Quality, Momentum, Size and Minimum volatility are the most robust, Carry is another (I’ll blog separately on what each of these are).
Most of these factors can be found across most “asset classes” e.g. equities, fixed interest, commodities and currencies.
- Factors exposures can be used to determine if an active manager is adding true excess returns (alpha – risk adjusted excess returns), or just providing a market factor exposure which can be gained cheaply. It is a tough environment for active investors, they are being squeezed by passive index funds and cheaper factor funds (sometime referred to as smart beta strategies). Albeit, a high level of sophistication is required in developing an effective factor investment strategy.
- Factor investing can deliver more efficient portfolios. This means better reward for risk taken. Well-constructed factor investment strategies eliminate or reduce the exposure to unwanted and un-reward market risks. The article uses an America’s Cup analogy of reducing frictions to make the boat go faster– note New Zealand is the current holder of the America’s Cup.
Therefore, factor investment strategies can provide a more efficient portfolio outcome than selecting Industry Sectors or active management by way of example.
- Not all factors will perform equally well at every moment. Factors can underperform the wider and broader equity market and the other factors for long periods of time e.g. the Value factor has underperformed the broader global equity index for about 10 years currently!
Therefore, diversification across the factors is often recommended.
From a more advanced perspective, a portfolio that invests across multiply factors across multiply asset classes, and that can invest both long and short, e.g. go long stocks with favourable rewarding factors and sell short those stocks that do not display the rewarding factors, is likely the most efficient means of factor investing. Such a strategy could well make up an allocation within a Liquid Alternatives Investment Strategy.
As an aside and not to confuse:
The above factors e.g. value, momentum and carry are factors that can be used to explain the drivers of securities within an asset classes e.g. equities fixed interest, and currencies
There are also macro factors, these explain at a higher level what drives a multi-asset portfolio. Macro factors can explain more than 90% of returns across a multi-asset portfolio. These macro factors can be used to determine an appropriate allocation to the different asset classes e.g. equities versus fixed interest exposures given preferred risk tolerance and investment objectives.
Macro factors include, economic growth, real interest rates, inflation, credit, emerging markets, and liquidity. This is a topic for a future blog.
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