The Factor Box: a new lens

Jan 25, 2018

The capacity of factor strategies appears large 

Movies moved from black and white to color, showing the richness of the world in its true form. Shouldn’t the way we build portfolios and evaluate managers also evolve?

Casablanca. It’s a Wonderful Life. Citizen Kane. Rebecca. Roman Holiday.

I understand that these classics are beloved by many. But I have a different take. They’re in black and white and I prefer color. The world is in color, and I like my movies to reflect the full spectrum of color I see outside the movie theater.

Investments, like movies, also evolve with data and technology. Just as color and other technological developments revolutionized the movie experience, I believe the lens offered by the Factor Box can dramatically change how we construct and manage a portfolio of investments by offering a more complete picture of the underlying factors that affect a portfolio’s investment performance.

Lights! Setting the scene

In 1992, Morningstar introduced the style box, a simple and intuitive method for constructing a portfolio. The equity style box was a 3x3 grid dividing funds into nine boxes, using value and size factors — broad persistent drivers of returns—in today’s language of investing. The ease of choosing funds across styles in various boxes helped millions of investors to construct diversified equity portfolios, and provided an objective way to compare managers to their peers with similar investment styles.

The style box, circa 1992

The style box, circa 1992

Camera! Glaring style box limitations

While the style box has served investors well for almost 30 years, our knowledge about investments has significantly increased. We know that more factors than just size and value have been historically associated with long-run excess returns. A large body of academic work has shown that quality, momentum and minimum volatility also have empirically enhanced returns or reduced risk relative to market-capitalization index benchmarks.

The way we view investments should reflect the advances made in data and technology. With a new lens, we can make more informed investment decisions and more efficiently benchmark active managers.

Ready for a close-up: Introducing the Factor Box

The Factor Box transforms the style box concept, incorporating a more complete view of the dominant drivers of returns within equity markets. The Factor Box pushes from two factors to a full color array of factors. In my last article, I discussed how value, quality, momentum, size and low volatility have historically beat the market on a risk-adjusted basis and have strong economic intuition. The Factor Box also adds yield — a measurement of high and persistent dividend yields — because income considerations are important for many investors, especially for those in retirement.

The Factor Box shows exposures across six factors

The Factor Box shows exposures across six factors

The Factor Box displays the relative factor exposure of a stock or a group of stocks versus a comparative universe, such as the broad market. Factor exposures may change over time. For illustrative purposes only. The Factor Box should not be interpreted as a recommendation of any security or investment strategy.

Action! Using the Factor Box

We can use the Factor Box in a similar way to the style box, but with more depth and richness. We can:

  • Assess portfolio diversification. Do we have all, not just two, factors? If a portfolio lacks exposure to quality, for example, and has too much momentum, we can take appropriate action.
  • Evaluate fund exposures. Perhaps the factor exposures in a traditional actively managed fund can be obtained in a more efficient way with lower-cost, fully transparent, smart beta ETFs. The Factor Box can help find the most appropriate smart beta factor exposure.
  • Conduct due diligence. The Factor Box can analyze factor exposures for each security. This provides a transparent view of a fund’s actual exposures based on underlying holdings, not just the exposures the managers claim to be targeting. This can help when choosing between funds to fill an allocation.
  • Tilt dynamically. The snapshot provided by the Factor Box could help investors position factor exposures through the business cycle. Tactical investors who believe the economy is signaling for value to outperform, for example, could use the exposure insights of the Factor Box to reallocate within their existing holdings to implement a short-term tilt.
Andrew Ang
Managing Director, Head of Factor Based Strategies
Andrew Ang, PhD, Managing Director, coordinates BlackRock's efforts in factor investing. He leads BlackRock's Factor-Based Strategies Group which manages macro ...