19 May Building a Diversified Portfolio with Factor Investing
Asset class investing has long been accepted as the key to building portfolios that allow investors to meet their long term investment goals. We believe by diversifying investments between a wide range of asset classes such as large U.S. stocks, emerging market stocks, bonds, real estate, and more, investors can capture returns in a variety of different market conditions, the theory being that while some assets classes might be performing poorly, others will be doing well.
While this theory has largely held in the past, the 2007 financial crisis saw most asset classes falling sharply together, denting not only asset class based portfolios, but also investor confidence in asset class investing. This left many investors searching for alternative strategies to further enhance and protect their portfolios.
One of those strategies is factor investing. Factor investing relies on specific characteristics, or factors, of stocks that have been shown to produce excess returns. The most common of these factors are low volatility, size, value, momentum and quality. Investors usually target one or more of these factors through numerous ETFs. Many investors purchase an ETF without realizing it has a strong exposure to a particular factor, simply based on its weighting scheme.
Factor investing is not a new strategy, but it has become extremely popular since the financial crisis, with, according to Morningstar, $87 billion of new net cash flows in 2018 alone. As interest in the strategy grows with advisors and clients alike, understanding how factor investing works and when to use it in a portfolio becomes increasingly important.
Factor investing dates back to the 1960s with the introduction of the Capital Asset Pricing Model’s (CAPM) beta. Beta is just a measure of the risk of an individual stock compared to that of the overall market, and CAPM basically says that in order to beat the market, investors must take on more risk than the market. In other words, high risk equals high return.
Research by Stephen Ross in the 1970s suggested that CAPM’s beta was not the only characteristic that defined returns. His Arbitrage Pricing Theory held that it was a combination of factors which determined returns, though his research didn’t identify specific factors. That would have to wait until the 1990s, when Eugene Fama and Kenneth French introduced their Three Factor Model. Their new model held that, in addition to beta, size and value were also responsible for determining returns. Additional research has added momentum and quality to the list of commonly used factors.
Factor investing, of course, is not the end-all-be-all of portfolio construction. Not all factors perform well in all market environments and too much reliance on one factor can actually reduce portfolio diversity. Because of this, factors are often used to make portfolio adjustments to market forecasts and may be best suited to a core holding strategy that combines multiple factors to produce a portfolio that can do reasonably well under a variety of market conditions.
How factors get combined in a portfolio depend on market conditions and portfolio goals. The size factor targets small companies defined by market cap. Fama and French showed that smaller companies outperform larger companies over the long term. The outsized returns of small companies are generally attributed to the increased risk and reduced liquidity that small companies tend to exhibit. However, capturing this excess return can be difficult as this market segment can actually underperform the broader market for long periods of time.
The value factor, also from Fama and French, looks for companies that are underpriced relative to their peers. The theory is that underpriced companies have more room to grow than their more expensive counterparts and baring any underlying fundamental problems, those companies should eventually be priced similarly to their peers.
Low volatility is often used as a risk-mitigating factor. Low volatility companies can offer some downside protection while still providing good returns. Interestingly enough, some research shows that low volatility companies can outperform the market over the long term, flying in the face of CAPM’s widely accepted more risk equals more return theory. One downside to low volatility companies, though, is that they can significantly under-perform during bull markets.
The Momentum factor refers to the tendency of stocks that have recently risen in price will continue that trend over the medium term. One common theory is that investors can take a while to warm to good news from a company, and once they do, will continue to expect strong performance, driving the price ever higher until an event, either macro-economic or company specific, breaks those expectations.
Momentum stocks normally detect securities with large market share/revenue growth rates, which in turn, tend to inherently be high growth companies. Given that growth companies trade much higher relative to their future earnings than the market, they tend to surface as momentum stocks.
The quality factor is a little different from the others in that quality can be quite subjective. Quality is a measure of a company’s health and usually takes into consideration balance sheet strength, earnings stability and debt. Some analysts even use measures of governance strength in determining quality. The idea is that strong, well run companies with low debt levels should outperform their peers.
Factor based strategies offer investors opportunities to create well diversified portfolios while moving away from the asset class model. These strategies may reduce risk and produce strong returns compared to asset allocations, giving investors a new strategy with which to achieve their investment goals. Global Beta Advisors builds customized portfolios to suit investor needs.