Credit: Shutterstock photoFor investors and advisors, diversification is the single most important factor when constructing a portfolio. The benefits of diversification have been a long held principle in both the classroom and real world. The mix of stocks and bonds help balance the risk and rewards of investing, with equities designed to deliver robust returns and bonds intended to offset said volatility.
The entire concept is fundamental to basic investment strategies, but fell short during the 2008 Financial Crisis. The problem during this period was prices for both stocks and bonds moved in the same direction: down. When both asset classes move in the same direction, investors are exposed to a high degree of volatility and may experience extreme downside movements.
Good thing is, factor investing has been the latest effort to address the shortcomings of basic diversification. For institutional investors, who can afford large down periods, it is the optimal balance between risk and returns. By definition, factor Investing is an investment strategy in which securities are chosen based on aspects that are associated with higher returns. The MSCI currently identifies 6 key risk factors: Value, Size, Volatility, Yield, Quality, and Momentum. Historically, the combination of those factors has empirically proven to “safely” outperform the market over the long term.
Basics of Factor Investing
As the investment universe has grown beyond stocks and bonds, the drivers of returns have become less apparent. While healthy diversification should theoretically deliver returns, the real world often warrants a more complex strategy. Factor investing attempts to integrate the portfolio construction process within the framework of factor decisions.
The fundamental notion behind factor investing is that different factors complement each other in a way that outperforms the market through good and bad times. What’s more important, they tend to exhibit low correlation, as each factor is driven by different behavioral biases. The research that augments factor investing have led to a slew of factor based ETFs and Smart Beta assets in the last 5 years.
Theory Behind Factor Investing
Long-standing academic research has helped shape factor investing into what it is today. Factor investing draws its underpinnings from the capital asset pricing model (CAPM) derived throughout the 1960s. CAPM is simply a single factor framework whereby investment returns are determined entirely by its exposure to market factors and in this case, risk.
As the model has expanded over the past 50 years, so has the framework for factor based investing. Empirical research in that time verified risk adjusted returns were associated with specific market factors like size and value. Furthermore, the Fama and French three factor model in the 1990s validated the necessary exposure to three factors: risk, size and value.
Factors
Many of the most widely recognized factors are derived from academic research of the past 50 years. Each of these are intuitive and well-understood investment ideas used in developing the novel assets on the market today.
BlackRock currently offers iShares ETFs which track factors such as momentum (MTUM), value (VLUE), and size (SIZE) to name a few. While each factor is individually compelling, they are more intriguing when combined together, yielding a multi factor strategy. MSCI offers an array of multi-factor indexes which track numerous factors under one investment vehicle.
Practical Implementation
Lately, institutional investors are embracing factor based investing. In a survey of 200 institutional investors conducted by BlackRock, they found over 87% of all investment processes incorporated factors. The most cited benefit of using factors were to better understand risk and returns followed by increased diversification, reduce risk and increase returns.
The study also found that factor investors were more likely to pursue a single or multi factor strategy, like a Smart Beta strategy that has become more popular in recent years. A few additional benefits not mentioned in the above study, include transparency, cost efficiency and exposure control.
Final Take
Given the number of complex securities on the market, investing has become a tall order. However, complex doesn’t always translate to success and with a simple factor based strategy, you will be in better shape in the long run. Choosing the right factors to focus on will strike an ideal middle ground between losses and returns. As a result, many long term institutional investors have adopted a factor based strategy because over time, slow and steady wins the race.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
