It’s important to understand that while these factors have generated excess returns over the long term, they don’t always outperform over short periods. Investors should be prepared to hold their investments for long time frames in order to potentially benefit from factor strategies.
Passive factor strategies have enabled investors to seek higher than market return potential without giving up some of the attractive characteristics of passive investment strategies. By adding a factor tilt to otherwise passive portfolios, factor investors may be able to enhance returns over the broad market benchmark. Compared with traditional stock-picking strategies, factor investing strategies are generally chosen because of the predictability of results.
Based on the results of the Invesco Global Factor Investing Study 2018, new or additional factor investing mandates are generally funded from both market-weighted passive and more traditional active allocations, as well as from new cash flows.
Factor investing grew up in the equity markets as a way to add the potential for outperformance to cheap, transparent, passive stock exposure (or, conversely, to make the benefits of active management more systematic, predictable, and cost-efficient). As a result, many of the most widely used factors relate to equities. We have found, however, that factor analysis also works in fixed income, commodities, and currencies, with slight adjustments.
Making factors work in portfolios
Factor investing is an investment strategy in which securities are chosen based on certain characteristics with the goal of achieving portfolio outcomes — increasing returns, risk reduction, cost control or some combination of the three — in a transparent, structured, and disciplined way.
Of course, all portfolios have exposure to factors, whether they explicitly employ a factorbased strategy or not. Factor analysis simply helps investors understand what’s driving performance, how much risk they’re taking on to achieve it, and whether they could generate better returns (or reduce risk) by changing their allocation to various factors.
But the abundance of factor strategies available today paradoxically has made it more difficult for investors to achieve the increasingly specific return outcomes they seek. Many would-be factor investors wind up unintentionally taking on more risk. They may not fully understand the risks of the factor strategy they’re considering or the factor exposures of the portfolio they’re adding it to. To illustrate how factors are ever-present but not fully appreciated, when we looked at the factor tilts of over 600 actively-managed U.S. large- cap funds, we found that on average, relative to the S&P 500 Index, they were overweight on the size factor (toward smaller companies) and underweight on the low volatility and dividend yield factors.13
Moreover, as our research has shown, naively combining factors often produces unintended and less-than-ideal consequences. Part of the reason for this is that investments can have both positive and negative factor exposures. This means that an intended positive factor exposure in one investment might be nullified by a negative exposure in another. For instance, single factor value and momentum strategies tend to exhibit negative exposure to the other factor if not deliberately controlled. Investors need the expertise and the proper analytical tools to understand the potential interactions between the strategy and their current exposures — something even sophisticated investors may not possess.
Factor strategies can be powerful tools for pursuing enhanced returns in institutional portfolios, enabling investors to harness the power of persistent, broad-based sources of return in their investment strategies. But they’re tools that must be used skillfully, methodically, and tactfully, ideally by experienced practitioners.
At Invesco Investment Solutions, we take a consistent approach to factor investing, whether the client objective is greater returns, reduced risk, or cost control:
- We diagnose the client’s situation using Invesco Vision, our portfolio management decision support system, to identify and quantify the factor exposures already present in the client’s portfolios.
- We engage in a dialogue to gain a deep mutual understanding of the return goals, expectations, and desired outcomes across a variety of assumptions and possible environments.
- We build solutions with an open, unbiased mindset from a broad set of investment tools across traditional and alternative asset classes, active/passive approaches, and vehicles.
Where the industry is headed
Factor strategies are a relatively new addition to the asset management toolbox. The appetite for factor strategies appears to be strong, however, as investors begin to recognize the benefits of using them.
Institutional investors typically start by employing factor approaches in a portion of their asset allocation, usually equities, and expand from there into other asset classes. Investors have also generally begun their foray into factors by incorporating the most common style factors (equity market, size, and value), which mirror active strategies that are already familiar.
The objective of factor investing is normally strategic due to the long-term nature of investment factors. However, a tactical use of factors is also possible, for example, to express a market view. In this way, investors who expect a market trend to continue can focus on momentum strategies. Investors who may expect heavy volatility in equity markets in the future can hedge their bets with low volatility strategies instead. Factor investing can also be used in a targeted way to reduce portfolio risk – with the objective of giving the investment additional diversification. A note of caution, however: Applying factors that have historically delivered a premium over the long-term creates an additional hurdle that must be overcome when used tactically. Market trends and economic cycles can change quickly and, sometimes unexpectedly. To benefit from tactical applications, investors must determine when to get in and when to get out.
And finally, while most institutional investors take long-only positions in factor strategies, a few are implementing pure, long-short factor portfolios to capture absolute returns. For instance, a long-short momentum factor strategy might buy the top 10% of stocks that have outperformed their peers over some recent period, while shorting the bottom 10% of stocks that have underperformed over the same period. This type of portfolio can be very useful in seeking to deliver returns with a low correlation to the market. Having a long and short position effectively eliminates market exposure. What remains is a more direct exposure to the desired factor.
Adopting factor investing
As we’ve mentioned, factor investing is based on a solid foundation of rigorous research, much of it from academia.
In the end, the use of factor investing is not strictly about moving assets into factor strategies, but also about looking at a portfolio in factor terms, understanding the biases that create opportunity, and positioning investments for exposure to factors that can meet the organization’s goals. Fully adopting factor investing requires a shift in mindset across all levels of the organization, with buy-in particularly from senior leadership.
Factor investment is transforming money management as investors begin to supplement traditional asset allocation and security selection with factor-based approaches. Investors can start by looking at their existing portfolios in factor terms and understanding where they are over- and under-weighted. They can then deliberately position their portfolios across factors in an attempt to enhance performance.
Today, investor allocations to factor strategies are relatively small, but they are growing as investors become comfortable with the approach and recognize the benefits in return enhancement, risk management, and cost-efficiency. Factor analysis provides a way to improve understanding of what drives returns in a portfolio — and, at the same time, it creates the potential to improve performance without necessarily taking on more risk. For these reasons, factor investing is likely part of a permanent shift in the way assets are managed. If you’d like to explore how factor investing might enhance results for your organization, please contact your Invesco representative.
This article was written by the Invesco Investment Solutions team in collaboration with Invesco’s Global Office of Factor Investing.
Factor Investing: Introduction & Research
Factor Investing: The Third Pillar of Investing Alongside Active and Passive
Annual Invesco Global Factor Investing Study
^1 Invesco Global Factor Investing Study 2018, page 21.
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^12 “Taming the Factor Zoo: A Test of New Factors” by Guanhao Feng, College of Business City University of Hong Kong; Stefano Giglio, Yale School of Management NBER and CEPR; and Dacheng Xiu, Booth School of Business University of Chicago.Dec. 15, 2017
^13 “Factor investing: complementing portfolios with customized factor solutions,” Michael Abata, Georg Elsaesser, Brad Smith, Jason Stoneberg, Invesco Risk & Reward, #2/2017