Factor Basics Risks &
Implementing Factors for Targeted Outcomes

Implementing Factors for Targeted Outcomes

Four things to consider when adding factors to portfolios.

At their most basic level, factors are inherent drivers of performance — quantifiable characteristics that can help explain the risk and returns of a given asset or portfolio. Factor-based strategies may provide investors with the ability to achieve specific outcomes, including hedging or targeting certain investment themes or strategies to express a tactical market view.

1. 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. A portfolio that appears diversified by traditional style, and even asset class measures, may be unbalanced from a factor perspective, which can put it at odds with an investor’s long-term goals.

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

Factor analysis typically uses two methods to uncover factor tilts: Holdings-based analysis and returns- based analysis. Holdings-based analysis examines factor exposure by considering tilts within a given portfolio and is often better at capturing the effects of portfolio turnover. A returns- based approach uses regression analysis to uncover a factor blend with the lowest tracking error to historical returns, which may help anticipate longer-term trends.

With the right tools, investors can gauge factor tilts and customize factor exposures to help achieve specific investment goals. Ideally, the end result is a portfolio better aligned with an investor’s desired outcomes.

2. Choosing a factor implementation methodology

The choice of rules used in the construction of a factor strategy can have a significant impact on performance, so it’s worth understanding what they are. Key criteria to look for are: Factor observation variables, securities ranking methodology, rebalancing frequency, constraints, optimization methodology and costs.

Consider the value factor. Academic literature generally analyzes multiple criteria, such as price to book, price to earnings, price to cash flows and dividend yield. However, a factor portfolio manager may also include operating profit margin, gearing, enterprise value, non-price related metrics and other proprietary indicators. Portfolio construction may be designed to allow sector tilts or to neutralize any sector biases compared with a market-capitalization index.

3. Multi-factor versus single-factor strategies

Factor-based portfolios can use a combination of single-factor strategies or a multi-factor strategy. Multi-factor strategies attempt to create diversified factor exposure within a single strategy. The key variable is how much control the portfolio architect desires. Single-factor strategies often provide higher degrees of investor control, while multi-factor strategies leave more control in the hands of the manager or index. The accompanying chart lists additional features to consider.

4. 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 traditional passive index strategies and active managers. Consider the following three approaches for using factors to help deliver desired investor outcomes.

  • A core approach uses factor-based strategies as the core allocation, rather than passive benchmarks or traditional active management. Smart beta funds bring both market exposure and factor exposure without requiring leverage, and are therefore particularly useful in this approach.
  • A balanced approach begins with a traditional passive or active portfolio and introduces specific factor-based strategies to complement a portfolio. For example, a portfolio of active managers may have a tilt towards higher volatility and momentum. In that case, a low volatility and quality factor blend may create a more diversified factor exposure.
  • A customized approach starts with a core of traditional active management or passive exposure and overlays factor strategies to target specific investment outcomes. For example, a growth-oriented investor using a market-cap-weighted passive core could consider value and small size factor strategies to target higher long- term returns.

In summary, factor investing has the potential to create more precise asset allocation decisions. By customizing implementation strategies to desired outcomes, investors can unlock the true power of factor investing.

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Important Information

Low volatility utilizes rankings while seeking to minimize the impacts of market fluctuations. Quality seeks to capture excess returns to companies by indicators of quality as defined by profitability, quality of earnings, operational efficiency and managerial strength. Momentum ranks securities relative to peers using relative strength methodology to identify the strongest and weakest investment trends. Value seeks to capture excess returns to attractively priced assets. Small size seeks to capture excess returns to smaller market cap companies. Price-to-book ratio is the market price of a stock divided by the book value per share. Price-to-earnings ratio, also called multiple, measures a stock’s valuation by dividing its share price by its earnings per share. Price-to-cash flows ratio is a company’s market capitalization divided by operating cash flow. Dividend yield is the amount of dividends paid over the past year divided by a company’s share price. Gearing analysis compares a company’s long-term debt to its equity capital. Enterprise value is a measure of a company’s total value. Regression analysis is a statistical technique used to find relationships between variables for the purpose of predicting future values.

Beta is a measure of risk representing how a security is expected to respond to general market movements. Smart beta represents an alternative and selection index-based methodology that seeks to outperform a benchmark or reduce portfolio risk, or both, in active or passive vehicles. Smart-beta funds may underperform cap-weighted benchmarks and increase portfolio risk.

Diversification does not guarantee a profit or eliminate the risk of loss. The opinions expressed are those of Jason Stoneberg and Vincent de Martel as of March 28, 2018, which are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

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