Factor-based investing – are you and your clients up to speed?

Factor-based investing

  • Demographic shifts caused by baby boomers entering retirement
  • New regulations
  • The low return environment
  • A forensic look at costs

These are a few of the trends causing a growing number of investors to seek alternative, transparent and cost-effective investments that can help them bypass some of the common challenges of actively-managed funds and market-weighted indexes. These investors aren’t necessarily shunning traditional cap-weighted indexes or the principles of active management. Rather, many are looking for a way to optimize the range of active and passive strategies that may make up their total portfolios.

Increasingly, investors are turning to factor investing strategies (sometimes called smart beta) for this. It helps that implementing factor beliefs has become easier and more cost-effective as the instruments and trading strategies required have become more widely available. In our view, continued growth in adoption of factor investing appears likely.

For those not as familiar with factor investing strategies, a quick refresher may be helpful:

How factor-based strategies work: Factor based strategies are designed to add value by systematically selecting, weighting, and rebalancing portfolio holdings on the basis of an investment characteristics other than market capitalization.

The 4 most common factors used in equity investing, based on our research

  1. Value

One of the oldest forms of active equity investing, value investing focuses on companies with high intrinsic value, where the stock is selling at a market price below the true value. We often find that value investors can go for extended periods where their portfolios are underperforming the market, and then recover in a relatively short time.

  1. Momentum

Pioneered in the early 1990s, momentum investing presumes that if stocks have performed well for the past 12 months, they probably will continue outperforming the market for a short period in the future. Momentum and value tend to be negatively correlated – when value is outperforming the market, momentum often isn’t doing well.

  1. Quality

The most recent factor to join the list, quality investing considers three essential elements of a company: management efficiency, financial strength, and earnings profile stability. Quality is also considered one of the most stable factors, which means that excess returns can be fairly consistent over time. This factor also tends to see small active drawdown levels, but that means the excess returns delivered by quality are often not as strong as those from factors such as value or momentum.

  1. Low-volatility

It identifies stocks that display a lower level of risk than the overall market. Low-volatility equities often outperform when the market is falling, and frequently lag when the market is rising. From a performance pattern perspective, low volatility carries very low levels of absolute risk, but high levels of active risk relative to a cap-weighted index.

7 things to consider when choosing a factor-based strategy

  1. Due diligence

It is important to apply the same level of due diligence to a factor-based strategy as to any actively-managed portfolio.

  1. Long-term versus short-term performance behavior

The long-term performance of factor-based portfolios may be promising, but underperformance in the short-term is a real risk. Investors need a clear rationale for following a particular strategy, so they remain disciplined enough to stay the course during difficult times.

  1. Diversified mix of multiple factors

Investors should consider a starting strategic allocation to a diversified mix of multiple factors to attempt to achieve a smoother return stream. Although single factor exposures may be expected to outperform the market over the long-term, they may suffer prolonged periods of underperformance in the short term.

  1. Single multi-factor portfolio

Investors should consider a single multi-factor portfolio which aims to preserve the underlying single factor exposures but capitalizes on the cost-effectiveness of a single implemented portfolio.

  1. Value expertise

The quality of the factor construction and trading of the portfolio can have a meaningful impact on the return pattern of the strategy. This deep understanding requires expertise and resources.

  1. Intentional alignment with strategic beliefs

Investors should consider a holistic view of their portfolio to ensure the factors they are exposed to, from both active and passive strategies, are done so intentionally and are aligned to their strategic beliefs.

  1. Establish a reasonable time horizon

Given the variability in factor cycles, ensure that an appropriate time horizon is set to capture the factor returns over a full market cycle.

The bottom line

A number of trends are making factor investing a potentially attractive investment option for many investors. As with any investment, make sure your clients are aware of the benefits and drawbacks of such investments, and that they are clear about the role factor-based strategies can play in an overall portfolio.

Disclosures:

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.

This material is not an offer, solicitation or recommendation to purchase any security.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional.

The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity.

Russell Investments’ ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments’ management.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the “FTSE RUSSELL” brand.

The Russell logo is a trademark and service mark of Russell Investments.

Copyright © Russell Investments Group, LLC 2017. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty.

Russell Investments Financial Services, LLC, member FINRA (www.finra.org), part of Russell Investments.

RIFIS 18278

  1. No comments yet.

Millennials are the future.
Engage them now.

Millennial InvestorSubscribe to the Helping Advisors Blog and receive a free copy of the Millennial Investor.

We will only use your email for Helping Advisors Blog updates.