In my recent post "What to factor in and what to factor out?," I explained what the ‘factor’ in factor-based investing really means. While its acronym (FBI) gives the impression that it's rather complex, like the US organisation, investors have been increasingly looking to factor-based investing to drive their investment returns. It's time to consider why...
Factor-Based Investing (FBI) may not share the same motto with the Federal Bureau of Investigation but it has equally high aspirations, looking to make its mark on the investment landscape and a real difference to investors’ outcomes.
So what’s the role of FBI in our industry and how can it help you?
Since the global financial crisis, FBI has been knocking at the doors of many disillusioned investors. We believe investors are looking to factor-based investing for three key reasons:
- Active management… – Many investors currently holding exposure to ‘traditional’ market-cap weighted indices believe in systematic index-beating strategies so it is no wonder they would now look to generate better outcomes
- …with improved diversification – As a source of potential return that’s different from more traditional strategies, it can appeal to investors looking for better portfolio diversification
- …at a lower cost… – As fee pressure rises, clients are wishing to access some of the benefits of active management but at a much lower cost
Making the first step is always the hardest and some may need more time to become comfortable with this new way of investing.
However, over the last couple of years a large number of investors decided to take the plunge and gained exposure to single-factor smart beta strategies. Today many are taking this a step further by moving to a ‘multi-factor’ approach. As individual factors have their own cycles of performance, diversifying across a number of factors can help to smooth returns over time, leading to the potential for improved risk-adjusted performance.
Equities exposed to different factors are expected to perform differently at different points in time. In particular, since September 2003 smaller companies which are exposed to the ‘size’ factor, have produced higher returns than the broad market index, yet with greater volatility.
More defensive strategies, such as ‘low risk’ and ‘quality’ have also outperformed and limited the drawdowns at times of market stress. ‘Value’ underperformed, in particular over last 2-3 years.
Crucially, however, combining all five factors in a single portfolio has produced higher returns than the market-cap weighted index, but with lower volatility than many of the individual factors. A compelling example of diversification in action!
There is yet another role that FBI can play in your investment portfolio.
One can use factors while at the same time limiting the exposure to broader market risk, e.g. through an appropriate short position in equity futures. This leads to the creation of pure factor portfolios which generally have a low, sometimes even negative correlation to market returns – an appealing proposition for investors seeking additional diversification beyond traditional equity market exposure.
It’s clear that many ways of accessing these sources of returns have emerged – ranging from single factors to multi-factor composites and long/short strategies. This provides you with a lot of choice. However, your investment beliefs and objectives will ultimately guide you in choosing the best way that FBI can work for you.
Adapted from The rise of factor-based investing, Diversified Thinking by Andrzej Pioch and Aniket Das.