Factor, not just asset, allocation

Investing has been focused on asset allocation: diversifying across asset classes. Now, dig deeper to allocate across factors.

You can eat some wonderful meals ordering off the menu: appetizer, main course and dessert. But, sometimes you have to ask for something that’s not on the menu. Maybe you prefer a different flavor, have a medical condition or are training for a marathon.

The foods that make up our meals are like the asset classes used to build investment portfolios. We learned to dig deeper into the underlying nutrients, and we now dig deeper into factors — the underlying drivers of returns — to build our portfolios. Just as nutrients keep us well fueled, factors drive our portfolio returns.

Changing approaches to nutrition and investing

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

Start by figuring out which factors you own, decide which factors you want, and finally, map out a plan to get there.

Which factors do you own?

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

• Macro factors drive returns across asset classes. BlackRock’s research suggests that six factors explain more than 90% of these returns, with the three most important being economic growth, real rates and inflation. Credit, emerging markets and liquidity are the others. Equities are largely exposed to risks related to the strength of economic growth, while U.S. treasuries 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?

So, what combination of factors should you hold? The optimal factor mix will differ across investors, just as professional athletes and weekend warriors will have different nutritional requirements. Here are some “off-the-shelf” options you could consider:

1. Balanced macro factor exposure. A simple, but robust, benchmark would hold equal weights in the six macro factors to ensure the portfolio has maximum diversification. But, some investors may want larger weights in some factors in line with their preferences. 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 the drawdowns of equities while maintaining long-term return potential.
3. Both macro and style factors. We can combine macro factors at the whole portfolio with targeted style factors within certain asset classes. Because returns from style factors can be uncorrelated with macro factors, if implemented in a long-short approach, holding both macro and style factors can be highly diversifying.

How can you get there?

From your existing portfolio, you can start to add appropriate factor investments — smart beta ETFs or long-short, multi-asset mutual funds — to move to your optimal long-term mix.

Let’s look at a common problem: many investors have too much exposure to the economic growth factor. One way to address this is to trim developed market equities, and here are two options for consideration when reallocating:

• Option 1: Shift to a combination of assets with more exposure to inflation and real rate 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 sources of excess returns that an existing portfolio might not have.

Dig in!

Understanding the nutrients in our food doesn’t mean we give up food! It means that we have a deeper appreciation of the food that we eat and whether it’s helping us maintain a healthy lifestyle. Similarly, a factor lens helps us see what’s really in our portfolios and lets us adjust that allocation to meet our goals.

Diagnose which factors you own, decide which factors you want, and then pick tactics to bridge the gap. Then, you can celebrate with a nice dinner out, with well-balanced nutrients!