Factor Perspectives

Factors to pursue outperformance

Mar 29, 2018

Consider two factor strategies with the potential to deliver returns in excess of the market.

Factors are broad and persistent drivers of return that investors may choose to use in pursuit of higher returns, reduced risk and enhanced diversification. We’re going to focus on the first of those goals: how can investors use factors to try to outperform the market?

For investors who wish to seek outperformance through factor investing, two paths are available:

  1. Multifactor — a strategy diversified across multiple factors
  2. Factor tilts — leaning toward or away from individual factors

Factors can be cyclical

Every factor has economic rationale explaining why the factor has worked. Because these factors tend to be driven by very different reasons, they tend to pay off at different times.

These same rationales can also explain why performance can vary over time. Some investors avoid taking on certain sorts of risks, creating opportunities for others; structural market impediments can prevent some investors from taking on leverage; and behavioral biases cause some investors to favor certain stocks when others might be more sensible.

In value strategies, for example, investors have been paid a premium for being exposed to risk. During certain periods of market distress or economic troughs, value companies may underperform because they have large fixed capital costs — such as factories and specialized equipment — that cannot be easily converted to other uses. This inability to pivot often causes value companies to suffer compared to growth firms.

So, what’s a factor investor to do? The cyclicality of individual factors is unavoidable: short-term underperformance is often a requisite for earning a long-term premium.

1. Multifactor strategies

For investors looking to outperform the market over time, multifactor strategies are optimized to seek to provide diversified exposure to five equity style factors: value, size, momentum, quality and minimum volatility. Diversification means that when one strategy might underperform, such as value during an economic recession, another strategy — such as quality — might pay off. Factors tend to have low correlations with one another, so a multifactor strategy can potentially benefit in a number of market environments. Multifactor strategies can have sector, country and risk characteristics similar to well-known equity benchmarks. As such, they can potentially work well as long-term core allocations.

Multifactor portfolios can further benefit from a rebalancing bonus: they are periodically rebalanced back to targeted factor weights, providing a simple and powerful mechanism that seeks to buy low and sell high. The rebalancing process for smart beta strategies is automatic. This is important because buying when prices are dropping through the floor can be a difficult task for any human being. Similarly, manually pressing the “sell” button when prices continue rising can be challenging. A systematic rebalancing policy forces investors to do both, which can help lock in realized gains and ensure portfolios remain well diversified.

2. Factor tilts

For investors with particular insights and views, making modest tilts to express views might be appropriate. Investors may consider starting with a portfolio that’s diversified across the same five equity style factors as above. Then, investors who want to go further could implement modest tilts. This type of tilting, as distinct from in-and-out timing, can balance opportunities to seek improved returns while maintaining long-term exposure to all factors.

Determining whether to tilt toward or away from a factor relative to other factors could be based on each investor’s personal views. We prefer to consider four indicators when deciding whether to under-, neutral or overweight a factor:

  • Economic regime — if a factor tends to be helped or hindered in this phase of the business cycle
  • Valuation — whether a factor is expensive or cheap relative to its own history
  • Relative strength — whether a factor has had strong recent performance
  • Dispersion — how much opportunity a factor has now to outperform

Each of the four indicators is valuable on its own, but we think it is even more effective to combine these four insights into a composite indicator, which helps to inform our outlook for individual factors.

Conclusion

As with most things in life, an investor’s approach to factor investing does not have to be black and white. Many investors maintain a well-diversified multifactor investment at the core of their portfolio, making modest tilts to individual factors around that core. Such an approach takes advantage of the diversification benefits and the time varying nature of factors without tying the portfolio to the performance of any individual factor — allowing investors to embrace both the long- and short-term return potential of factor investing.