Consider the factors

Mar 21, 2018

The capacity of factor strategies appears large 

Investors may be able to construct better-diversified portfolios by incorporating factor insights into their asset allocation.

To understand how factors may help with asset allocation, investors need to figure out which factors they own, decide which factors they want to own, and map out a plan to get there.

Changing approaches to nutrition and investing

Changing approaches to nutrition and investing

For illustrative purposes. Basis points (bps) represent a factor’s hypothetical contribution to portfolio risk.

Which factors do you own?

There are two main types of factors: macro and style.

  • Macro factors drive returns across asset classes, and BlackRock’s research suggests that more than 90% of asset-class returns can be explained by six factors: economic growth, real rates, inflation, credit, emerging markets and liquidity. Equities have significant exposure to risks related to the strength of economic growth, while government bonds are driven by real interest rates and inflation.
  • Style factors explain returns within asset classes. Academics and practitioners have long found that cheap stocks (value), stocks that are trending (momentum) and stocks with higher quality earnings (quality)—to name a few factors—tend to outperform the market over the long run. We observe the same style factors in fixed income, commodities, foreign exchange and other asset classes.

Which factors do you want to own?

The optimal factor mix will differ across investors. Here are three options to consider:

  1. Balanced macro factor exposure. A simple, but robust, benchmark would hold equal weights in the six macro factors to create a well-diversified portfolio. But some investors may prefer larger weights in certain factors. For example, an investor concerned about drawdowns may allocate more to defensive factors, such as real rates and inflation.
  2. Style factor exposure. Style factors such as value, momentum, quality and size can enhance returns relative to a market-capitalization benchmark. For the more risk-averse investor, minimum volatility strategies can help reduce equity drawdowns while maintaining long-term return potential.
  3. Both macro and style factors. We can combine macro factors at the portfolio level with targeted style factors within certain asset classes. Because returns from style factors can be uncorrelated with returns from macro factors, if implemented with a long-short approach, holding both macro and style factors can be highly diversifying.

How can you get there?

Institutions can add a variety of investments—from smart beta strategies to long-short, multi-asset strategies—to their existing portfolios to achieve their desired factor exposures.

We have found that many institutions are heavily exposed to the economic growth factor and are looking to diversify some of that exposure into other macro factors. One way to do this is to trim allocations to developed market equities. Here are two options to consider when reallocating:

  • Option 1: Shift to a combination of assets with more exposure to the inflation and real rates factors, such as TIPS or developed market bonds, plus a multifactor smart beta strategy. This boosts exposure to factors that have been highly diversifying to the economic growth factor, and adds style factors to enhance return potential.
  • Option 2: Redeploy into strategies targeting macro and style factors to optimize risk and return goals. This diversifies across return drivers, and can add additional potential sources of excess returns.