Following on from my last post on Factor Investing this article provides some good insights into the implementation of a factor portfolio.
The article makes a few key points:
- The best way to capture the different factors is through diversification i.e. diversify across the different factors: value, momentum, size, minimum volatility and quality. Avoid having a single factor exposure.
- Although factors work, their performance vary greatly given different underlying financial and economic environments (macro environment).
- It is difficult to pick when the macro environment will change to the benefit or otherwise of an individual factor. Therefore, successfully under or over weighting a factor to expected changes in the macro environment offers little value add. It is nevertheless likely to be more fruitful than making country and sector allocations shifts based on anticipated changes in the macro environment.
- There are a number of approaches to constructing a factor portfolio. Most often implemented are equally weighted approach (i.e. equal allocation to each factor) and risk weighted approach. Risk weighted, in simple terms, starts with an equally weighted portfolio, then reduces the portfolio allocation to the higher risk factors e.g. more volatile factors, and increases the portfolio allocation to the less risky factors (in practice this is a more sophisticated and technically advanced approach). Whichever approach is implemented, it needs to be consistent with Investor’s risk appetite and investment objectives.
The implementation of a robust factor portfolio is more complicated than outlined above. There are a number of nuances that need to be considered e.g. level of portfolio turnover and redundancy of portfolio holdings i.e. a portfolio holding could enhance one factor but dilute another factor exposure.
Finally, the article makes a key point, this applies in any portfolio, robust portfolio construction is the key to success in Factor Investing.
True portfolio diversification isn’t easy. Many portfolios have lots of asset classes, this does not mean they have more diversification. See More Asset Classes Does not Equal More Diversification, the failings of diversification.
A more robust portfolio is achieved through factor allocation than say sector allocations, so long as there is a broad set of factors to invest in.
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