The value and benefits of diversification are long-held investing principles. The mix of stocks, bonds and cash in your portfolio helps you balance the risks and rewards of investing, with the stock allocation designed to deliver high-octane returns, and the bonds and cash designed to offset volatility and provide a measure of protection for your portfolio. The entire concept is based on the idea that stock and bond prices generally move in opposite directions - when one is rising the other is falling. This strategy was at the heart of portfolio construction for generations … until it didn’t work.
The financial crisis that began in 2007 and the recovery period fostered by central bank efforts to maintain low interest rates both have something in common. Asset prices for stocks and bonds moved in the same direction during both periods. Even so-called “alternative investments” like hedge funds moved largely in the same direction. During the crisis, the value of these asset classes fell. During the recovery, their value rose. Clearly, diversification and traditional portfolio construction weren’t working in the traditional and expected manner.
When stock and bond markets move in the same direction, investors can experience extreme movements in the value of their portfolios. While nobody minds when the movements are to the upside, extreme downside movements can result in the need for individual investors to delay a planned retirement and/or the inability to make key purchases. For institutional investors, it can result in funding shortfalls.
Factor investing seeks to identify and mitigate risk factors to build a truly diversified portfolio.
Factor Investing: Basics
While holding a mix of stocks, bonds and cash results in a portfolio that holds a diverse array of asset classes, when all of these asset classes move in the same direction, the benefits of diversification are lost. Rather than focus on diversification at the asset-class level, the financial services community is developing strategies that focus more on specific securities within and across asset classes.
For example, rather than having an allocation to stocks versus bonds, the stock allocation could be divided between stocks associated with high volatility and stocks associated with low volatility. This creates a portfolio with smaller up or down movements than the fluctuation associated with the overall stock market. This portfolio would be expected to gain less than the general market when prices are rising and lose less when prices are falling. The result would be a smoother path and more consistent returns for investors. Professional investors often take this tact. Their goal is to focus on delivering “risk adjusted” results that deliver the same or better investment returns as the overall market but with less risk.
Of course, outperforming the market is always an attractive investment goal. Investors don’t want to pay for below-average results, and investment professionals that deliver below-average results over long time periods tend to go out of business. Accordingly, an investment strategy that delivers second-quartile results year after year will likely find a fan base of happy customers. Being just a little bit better than most of your peers all of the time has more appeal than beating your peers once in a while but trailing them just as often. In an uncertain world, predictability has value in more ways than one. For investment professionals, achieving this objective is the challenge - and building a multi-factor portfolio may be the answer.
Factors, Factors Everywhere
Investing is a complex endeavor. A myriad of factors ranging from economic strength, central bank policy and technological development to geopolitical risk, natural disasters and fraud all influence the financial markets. Determining which of these factors is the most relevant and constructing a portfolio around the associated volatility is a tall order. There is no universal set of factors that all investment professionals agree on and no universal portfolio for investors to purchase. While many investment firms position factor investing as a long-term endeavor, short-term allocation changes may also play a role to address both current market conditions and the pressure from investors to “do something” in response to market events.
Choosing the right factors to focus on is largely related to an investor’s goals and investment time horizon. If retirement is the goal and 30 years is the time horizon, focusing on short-term interest rates and month-to-month fluctuations in portfolio value won’t help you reach your goals. If you are retired and need monthly income to help you pay the bills, focusing strictly on long-term capital appreciation is of little value.
Clearly identifying your goals and the factors likely to affect your ability to achieve those goals is at the heart of factor investing. Interest rates, credit quality, inflation and liquidity may be the biggest concerns for one investor, while economic and geopolitical risk may be the biggest concerns for another. Even among factor-investing proponents, there are those who argue for or against a variety of factors, with value, size, momentum and volatility popular among some segments of the field and not others. Figuring out the relevant risks, and then constructing a portfolio designed to mitigate them, involves planning and effort.
Successful factor investing depends on a variety of things, including security selection, investment strategy, personal behavior, timing and luck. There are no guarantees that you will choose the right strategy or factors. And even if you are correct, there are no guarantees that you will choose the right investment vehicles to make the right calls with the exact timing for gaining or eliminating exposure to the various factors.
Short-term investors may have visions of jumping in and out of factors to keep their portfolios rising, but decades of study by leading research provider Dalbar demonstrates that investors are likely to make the exact wrong decision. For 20 years ended in 2012, Dalbar’s report on "Quantitative Analysis of Investor Behavior" revealed that switching between funds frequently is likely to get one in and out of the market at the wrong times. This often results in investors buying high/selling low by failing to hold their investments over long time periods.
Even long-term investors face the risk that markets may not move in their favor, and that the timing of outperformance may not coincide with your need for liquidity. Like all investment strategies, factor investing subjects investors to a variety of risks.
The Bottom Line
If you are looking to use factors to supercharge your short-term returns and turn you into a market-timing guru, history suggests you will likely be disappointed. Long-term investors may be able to generate market-beating returns, but you need to have the fortitude to maintain the strategy when it is underperforming the market. Keep in mind that a given strategy can underperform for years before surging ahead to generate such significant gains that the overall portfolio return is above average. If you are looking to use factors to reduce risk in your portfolio and generate more consistent returns, you may be in luck. Delivering consistent results over a long time period may never put your portfolio at the top of the short-term performance charts, but it won’t put it at the bottom either. Over time, slow and steady just may win the race.
Investing BasicsMinimizing risk while maximizing return is any investor's prime goal. The right mix of securities is the key to achieving your optimal asset allocation.
Mutual Funds & ETFsGiven that stock picking is not generally effective, trackers that simply follow an index have become very popular. However, trackers have their disadvantages, too, so hybrid models between the ...
Investing BasicsFind out how you can streamline your investments for greater returns.
Personal FinanceFrustrated stock pickers rejoice - asset class selection is simpler and safer.
RetirementIs there a magic number you should be aiming for? Find out here.
Chart AdvisorThere has been lots of hype around the IPO market lately. We'll take a look at whether now is the time to buy.
ProfessionalsLearn what a typical early morning to late evening workday for a hedge fund manager consists of and looks like from beginning to end.
Stock AnalysisWal-Mart is the largest company in the world, with a sterling track-record of profits and dividends. So why has its stock fallen sharply in 2015?
Investing NewsThe force is strong with Disney stock, as it continues to make gains going into the launch of EP7. But is this pricey stock a good buy at these levels?
EntrepreneurshipLearn how a complete risk management plan can minimize or eliminate your financial exposure through insurance and prevention solutions.
The Vanguard mutual fund family is one of the largest and most well-recognized fund family in the financial industry. Its ... Read Full Answer >>
Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
Mutual funds in India work in much the same way as mutual funds in the United States. Like their American counterparts, Indian ... Read Full Answer >>
Like most financial assets held by institutions such as banks and investment firms, UTMA accounts can be escheated by state ... Read Full Answer >>
While the specific dormancy and escheatment rules for stock accounts vary by state, all states provide for the escheatment ... Read Full Answer >>
Mutual fund investors have numerous items to consider when selecting a fund, including investment style, sector focus, operating ... Read Full Answer >>