The investment strategy that can reduce the risks of your portfolio
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For decades, the hallmark of a sound investment plan has been portfolio diversification: a relatively simple concept that is tantamount to not “putting all your eggs in one basket”. By incorporating a healthy mix of investments across a range of asset classes, sectors and geographies, investors can theoretically minimize the likelihood of concentrated losses in one area.
While this conventional wisdom still carries weight, the realities of the 21st century market have challenged many existing assumptions about diversification. The negative correlation between asset classes such as bonds and equities was once considered a mainstay of portfolio construction, but is increasingly seen as under threat. A longer-term change in this relationship, which means bonds and stocks would fall in concert, could make it increasingly difficult for investors to create low-risk portfolios.
These changing dynamics are among developments that have accelerated the wider adoption of factor investing, an approach that can help investors understand changing market conditions and mitigate risk in their portfolios.
What is factor investing?
Factor investing is based on the principle that there are various attributes, or factors, that underlie the performance of each investment. These are well-studied, quantifiable and measurable characteristics that have demonstrated a reliable correlation with returns over time. By targeting exposure to these factors in their portfolio, investors can benefit from increased diversification and potentially higher returns.
Think of it like a car. All passenger cars on the market include several essential components, such as the engine, battery, tires, and chassis. However, the owner may decide to make adjustments or modifications to these components based on their specific needs. For example, they can buy performance tires for acceleration or snow tires to maintain traction in tough conditions. Others might consider a suspension upgrade for more precise handling and braking.
Just as a car owner can target features that make their car better suited to their performance and safety needs, factor investing offers investors a more thoughtful and customizable approach to meeting their portfolio’s risk and return goals. . And because the factors generally have low correlations with each other, investors can use them to diversify a portfolio across different underlying characteristic risk factors.
Related: The difference between direct indexing and ETFs
What are the different types of factors?
Factors generally fall into two main categories: macroeconomic and style. Macroeconomic factors explain risk in several asset classes and include concepts that are likely somewhat familiar to most investors – things like inflation, gross domestic product (GDP) growth and interest rates .
Style factors, which are the most commonly implemented, can help investors identify risk and reward factors within asset classes. They understand:
Assess. We all love a bargain. This factor leverages fundamental analysis to help investors identify and buy quality companies whose attractive stock prices belie their promising fundamentals.
Cut. Bigger is not always better. Factor investors can target small-cap stocks which, although generally riskier investments than their large-cap counterparts, can offer significant growth potential for long-term investors.
Quality. It reflects the overall sustainability of a business and is typically assessed using criteria such as debt level, earnings and asset growth, leadership credibility, and accounting practices. Many of these same metrics are important for sustainable investors, especially those focused on strong corporate governance.
Momentum. While the ubiquitous “past performance is no guarantee of future results” is entirely sound advice, momentum recognizes the tendency for stocks that have performed well recently to continue to gain in the short term. Factor investors typically implement momentum by picking stocks that have gained in the previous three to 12 months, typically ignoring the most recent month’s performance.
Volatility. Research suggests that stocks with more stable return patterns are likely to outperform those with a history of large price swings. This factor is captured by looking at the standard deviation of price changes over a period of one to three years.
Related: The Unexpected Parallels Between Dating and Angel Investing
Why factor investing?
Factor investing is a fairly intuitive proposition. After all, knowledge is power, and expanded access to financially important information can help investors make more informed decisions about the contents of their portfolio. This is an idea already familiar to many sustainable investors; in fact, we often hear environmental, social and governance (ESG) investing referred to as “all-information investing”. Indeed, it goes beyond traditional financial analysis to provide a more informed view of how a company manages risks and opportunities.
Factor investing itself isn’t new — it’s a strategy that active managers have been offering for years, often at a premium. However, as with many areas of capital markets, its wider adoption has been accelerated by rapid advances in data science and technology. Passive managers are now able to offer profitable index exposures that can be biased towards specific factors, as well as tailored to clients’ preferences regarding ESG issues, tax management and tracking error. From there, the platforms take care of the continuous rebalancing of the portfolio to minimize active risk.
It’s the best of both worlds: the flexibility and tax optimization benefits of active management, with the price transparency and efficiency of passive strategies.
Related: The Growth of Sustainable Investing