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Where are the factors?

Holly Framsted |Dec 9, 2019

Investors increasingly are using factor strategies, but you wouldn’t know it from their portfolios. Where are the factors?

My colleagues and I have written repeatedly about the fact that factors are long-term drivers of investment returns. Given this, it’s no surprise that investors are increasingly adopting factor strategies in their portfolios. In fact, we’ve seen record inflows YTD with over $18 billion in investments in iShares Factor ETFs. Logic would follow that investors’ portfolios exhibit meaningful factor bets or tilts. Yet, their actual exposures tell a very different story.

After analyzing the factor exposures of nearly 10,000 portfolios, my colleagues Andrew Ang, PhD, who is the head of BlackRock’s Factor Based Strategies Group, and Patrick Nolan, CFA discovered that investors have barely any factor exposure in their equity portfolios. But viewing their whole portfolios—across equities, bonds, and potentially alternatives and other investments—they may have too much exposure to economic growth.

In my recent conversation with Andrew, we dug a bit deeper into this finding and what it means for investors.

Holly: Before we dive into the results of your study, can you help us understand what factors are?

Andrew: Sure. Factors are broad and persistent drivers of returns. We see the effects of factors across asset classes and geographies—so they are broad, and they have exhibited persistently rewarded returns over long time periods. There are two main types of factors: macro factors, like economic growth, real rates and inflation, which explain the majority of the returns across many asset classes, and style factors, which allow us to select securities which potentially offer higher risk-adjusted returns within each asset class than the broad market. Style factors include value, quality, momentum, low size, and minimum volatility. While investors get exposure to both macro and style factors through their asset allocation, we often find that they focus more attention on style factors.

Holly: In your research, you analyzed approximately 10,000 portfolios. What were some of the main takeaways regarding how investors are allocated to factors?

Andrew: The most surprising insight was that while we have identified a variety of different factors that have historically driven returns over the long-run, investors currently only have meaningful exposure to two of these factors. The first is a macro factor – economic growth. And they probably have too much exposure to economic growth meaning that their portfolios might lose more than they intended when the economy slows. Not surprisingly, stocks are sensitive to changes in economic growth, and thus stocks tended to be the primary driver of risk in the portfolios analyzed.

The second is that within equities, investors barely have any style factors. The only style factor they have meaningful exposure to is low size, or more commonly thought of as smaller companies. However, we were very surprised to learn of the lack of diversification across style factors within the portfolios. Investors could potentially enhance returns or reduce risk by adding meaningful value, quality, momentum or minimum volatility factors.

Holly: What’s the rationale behind these concentrated exposures?

Andrew: In some instances, these larger-than-expected exposures to economic growth and low size are intentional; they are a result of a deliberate asset allocation decision. However, in other instances, these factor exposures are not intentional, they are an unintended side effect of individual fund choices in a portfolio. Sometimes in equities, investors hold several different active managers and the style factor exposures selected by one manager cancel another manager’s! Intentional or not, we believe many investors have the opportunity to potentially enhance return and/or reduce risk by diversifying their portfolios further.

Holly: How so?

Andrew: For example, investors may be able to improve the resilience of their portfolio, particularly ahead of a potential economic slowdown, by doing one or two things: First, they may consider reducing their exposure to economic growth and increasing their exposure to other macro factors by selling stocks and buying treasury bonds. Second, investors can increase exposures to other style factors to add diversification or specifically to those that have done well in the later stages of the economic cycle.

Holly: In fact, we’ve been seeing a lot of client interest in quality and minimum volatility strategies lately.

Andrew: In an uncertain and slowing economic environment like we find ourselves in today, there are two style factors, quality and minimum volatility, that have tended to outperform. Quality strategies tend to invest in profitable companies with low debt and stable earnings while minimum volatility strategies aim to create a holistic portfolio with lower risk than the market. For investors most concerned about introducing resilience into their portfolios, whether in response to the economic environment, or simply as an always-on strategy, quality and minimum volatility can be powerful additions.

Typical Factor Behavior throughout a Global Business Cycle

Typical Factor Behavior throughout a Global Business Cycle

For illustrative purposes only.

Holly: That’s very interesting. How might investors benefit if they were to increase their exposure to either of these factors?

Andrew: Quality and minimum volatility strategies may offer investors the opportunity to diversify their factor exposure while also better positioning their portfolios for the current economic environment. As both strategies have historically outperformed in periods of market decline, investors may want to consider using these factors to build resilience into their portfolios. One way to look at resilience is through upside and downside capture. In other words, how much does the strategy gain when the market trends up, and how much does it lose when the market trends down? Quality and minimum volatility provide investors with lower downside capture while still allowing for upside market participation.

Up and down capture
(January 2015 – September 2019)

Up and down capture

By creating a potentially less volatile investment experience, quality and minimum volatility strategies may help investors remain invested during periods of market stress and uncertainty.

Holly: Thank you Andrew for your time and insight. It’s been great to learn how investors can use factors to deliver better outcome for their portfolios.

Holly Framsted
Holly Framsted, CFA, is the Head of US Factor ETFs within BlackRock’s ETF and Index Investment Group