How to use factors to tailor your investing

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Factor-based investing has gained greater attention in recent years, in part because of the rise of alternatively-weighted indexes and ‘smart-beta’ products.

However, investing in factors is nothing new. Benjamin Graham and David Dodd published ideas on what we now call value investing in their book Security Analysis published in 1934.

Portfolios might tilt towards or away from certain factors. What is new about factor-based investing is using the factor lens to evaluate portfolios, crediting factors for their impact on risk and return.

Today, value investing is considered one type of factor strategy – with minimum volatility, quality, momentum and liquidity being other common factor strategies.

We think of factors as the DNA of an investment – the underlying attributes that explain and influence how an investment behaves. Factor strategies leverage the positive effects of factor exposures through systematic, diversified, and disciplined tilts.

With an increasing array of factor funds on offer, deciding what’s right for your portfolio can be difficult. By keeping some fundamentals in mind, investors can work out what might genuinely assist in reaching their financial goals.

Align your goals with your investment choices

How you use factors when constructing a portfolio depends on your goals. Rather than targeting pure outperformance with factor funds, you might be better off considering the kind of characteristics a certain factor can add to your portfolio. Your goals may involve specific time-horizon constraints, or varying risk profiles.

For example, those in pension phase with concerns about volatile markets may see the benefit in using a factor fund focused on minimising volatility in part of their equity exposure. This might apply especially when reallocating too large a sum to fixed interest could jeopardise the capital growth required to protect against outliving assets.

Historically, an investor may have looked towards equity funds that emphasised ‘defensive’ sectors or those with higher dividend yields for volatility reduction. However, while lower volatility can be, at times, a by-product of these types of strategies, it is not the objective. Additionally, products like these may lack proper diversification and not provide the downside protection when needed the most.

A minimum volatility strategy is optimised to provide equity returns with lower volatility than the broad markets in a diversified portfolio.

Alternatively, a growth-oriented investor might conclude that the style characteristics of their total global equities portfolio are not appropriate for the level of desired risk. If the investor wishes to maintain the outperformance potential of their existing funds while reducing the active risk, they could allocate a portion of their global equities portfolio to a value fund providing a value equity factor tilt.

Active or index?

Historically, investors may have accessed factor exposure through non-market capitalisation, index-weighted strategies. However, we view any portfolio that uses a non-cap-weighted scheme as an active portfolio. Factor-based investing uses factors like value, minimum volatility or a tilt to a certain sector to outperform the broader markets.

Using an active approach to factor implementation can provide greater control over factor exposure and reduce factor drift in the portfolio, with the flexibility to change portfolio holdings as needed. This is because positions can be adjusted as needed in order to maintain continual dynamic exposure to targeted factors.

Adopting lower cost active management to replace higher cost traditional active funds can remove one of the most persistent headwinds to active outperformance.

Consider the risks

Using factor products can help you employ a transparent, controlled active approach towards meeting your goals, but factor investing is not without risks. Similar to many forms of active management, factors can perform inconsistently and experience sustained periods of underperformance.

Factor-timing is difficult, in fact like any active tilt, factors carry higher risk relative to the broad market, and demand patience and conviction from investors. They must have the ability to resist the urge to sell down underperforming active positions which may recover and provide outperformance over the longer term.

Rather than trying to identify a sure-fire solution for outperformance in all market cycles, factor strategies should match your investment objectives and be sure you have the patience needed to stick with the strategy over the long term.

 

Michael Roach is Head of Quantitative Equity Group at Vanguard Australia, a sponsor of Cuffelinks. This article is in the nature of general information and does not consider the circumstances of any investor.

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