How factor strategies can work in a portfolio

Knowledge is power. At their most basic level, factors are quantifiable characteristics that can help explain the risk and returns of a given asset or portfolio. This is true whether or not a factor-based investment approach is used, which is why investors are increasingly looking to understand and manage their factor exposures explicitly.

Factor-based strategies may provide investors with the ability to achieve specific outcomes, including long-term adoption, in an attempt to improve risk-adjusted returns or tactically to express a market view.

Where do factor-based strategies fit within a broader portfolio?

Factors are an inherent component of all investment portfolios and, we believe, should be considered a core component of understanding and constructing portfolios. By extending the analysis of the portfolio beyond asset classes to include factor exposures, investors or their advisors have more useful information to better understand risks, evaluate investment options and formulate an investment strategy.

When determining how much to invest in specialist factor strategies, investors should first evaluate existing factor exposures, and, second, test the effectiveness of exposure changes in light of investment objectives.

Multi-factor versus single-factor strategies

Factor-based portfolios can use a combination of single-factor or multi-factor strategies. Multi-factor strategies attempt to create diversified factor exposure and improve efficiency by simultaneously evaluating securities across multiple criteria. Single-factor strategies often provide higher degrees of investor control, while multi-factor strategies give more flexibility to the investment manager.

How to combine index-based and active strategies

Regardless of whether investors pursue a single or multi-factor approach, factor strategies can be implemented in concert with market-cap weighted passive index strategies and with traditional fundamental active strategies. Consider the following four approaches for using factors to help deliver desired investor outcomes.

• Pursue higher long-term returns: Due to the compounding effect, even modest increases in returns over a long period of time can dramatically increase long-term returns. A core approach targeting factors expected to deliver a premium can improve expected returns over market weighted passive strategies that seek only to replicate market returns. Factor investing funds can bring both market exposure and factor exposure without requiring leverage. Higher risk may accompany higher expected returns, so investors who wish to manage near-term volatility should be wary of pursuing higher returns in this way.
• Reduce or control risk: Market weighted strategies generally bear full market risk, while traditional active strategies tend to make concentrated bets. Factor strategies can complement or replace portions of the portfolio to diversify market risk and/or security specific risk. For example, adding funds with specific exposures to the low volatility and quality factors, which historically perform relatively well in declining markets, may improve diversification across the combined portfolio by reducing total market risk and decreasing the concentration in the largest holdings without necessarily sacrificing returns.
• Customise exposures: Investment objectives may include constraints and priorities that differ across investors. Common examples include environmental, social or good governance priorities (ESG). Since factor strategies are data driven and systematically invest across broad groups of securities, accommodating such items is achievable in factor portfolios in parallel with the return generating mechanism.
• Control total portfolio costs: High-conviction strategies seek to add excess return, or alpha, but typically come at a premium cost. Balancing good alpha strategies with a relatively low-cost factor approach can help to reduce total costs of the portfolio.

In summary, factor investing is a well-founded systematic approach that can be complementary to other strategies. Understanding the factor exposure in a portfolio improves clarity, enabling more informed decision making. By customising implementation strategies to desired outcomes, investors can unlock the true power of factor investing.