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