Investing in different asset classes often keeps your portfolio on an even footing when the market wobbles because diversification helps minimize risk. Traditionally, investors have relied on a mix of stocks, bonds and alternatives like real estate or managed futures for diversification.
In the last 10 to 15 years, however, factor-based investing has been gaining momentum, says Rob Kolb, partner at Go Green Financial & Insurance Services in Rocklin, California.
Factor-based investing, also referred to as smart beta, involves choosing investments based on certain characteristics or attributes that are associated with a higher rate of return or reduced risk exposure. These attributes, or factors, can be divided into distinct categories: economic and style. The former consists of factors broadly affecting the economy, such as interest rate fluctuations, inflation and economic growth. The latter, which includes momentum, value and size, considers risk and return within asset classes.
[See: 10 Smart-Beta ETFs That Will Help You Get Your Alpha.]
Investors are using factor-based investing as a way to bridge the gap between traditional active and passive investment strategies to form a more perfect union, Kolb says. The goal is to merge the advantages of both strategies. Passive investing appeals to investors because of its low cost, low maintenance and transparent nature. Active investing, by comparison, offers the potential for outperformance but brings with it additional costs and idiosyncratic risk. The latter refers to the possibility that an asset’s price may decline because of an event that affects the asset but not the larger market.
Factor investing “offers a systematic, evidence-based way to approach the goal of outperformance, ideally keeping costs and idiosyncratic risks low,” says Dana D’Auria, director of research at Glastonbury, Connecticut-based Symmetry Partners. Although incorporating a factor-based approach into your portfolio may increase diversification, it takes some know-how to get it right.
Factor investing requires staying power. One of the biggest missteps you can make with any investment strategy is panicking when market movements don’t fit your expectations. If you’re going to invest using factors, you need to be prepared to ride out your investments over the long term. “If you buy an actively managed mutual fund, you have to expect that there will be times when the fund underperforms an index fund,” says Jeff DeMaso, co-editor and director of research for The Independent Adviser for Vanguard Investors newsletter. “No manager or strategy outperforms all the time.”
DeMaso says the same principle applies to factor investing, because factor portfolios don’t look exactly like the market. There will be times when a particular factor is in favor and times when it’s not. “If you aren’t prepared to hold on when the factor is out of favor, you either have no business owning factors or need to have incredible or lucky timing.”
Factor investing potentially allows you to beat the market, but your ability to do so depends largely on how you react to up-and-down market cycles. D’Auria says trying to time when to get in or out of a factor can be as difficult as timing the market in general. And there’s little evidence to suggest that using valuations or economic indicators can allow investors to time factors reliably. At the end of the day, “most investors will be better off investing for the long haul in a strategic factor-based allocation than in trying to time them in relation to the market cycle.”
[See: 9 ETFs That Go Up When the Market Goes Down.]
Factors aren’t perfectly synced. Factors move in cycles, just like the market, and they don’t always move in tandem with one another. That’s important to understand if you’re using factors to diversify.
Ryan Shelby, head of factor solutions for Wells Fargo Asset Management’s analytic investors team in Los Angeles, says factor investing offers opportunities for diversification not often seen in traditional equity strategies. Value and momentum, for example, typically have a negative correlation, so when one does well, often the other does not. Other factors, such as low volatility, tend to be negatively correlated with the market itself. The right combination of factors can enable investors to capitalize on higher risk-adjusted returns that experience fewer declines.
Building a diversified core strategy should encompass all five style factors: size, value, momentum, quality and low volatility, says Rob Nestor, head of iShares smart beta at BlackRock. A portfolio using only one to two factors at a time is at a disadvantage, but investors may be able to earn additional returns by tilting their investments. This involves modestly over- and underweighting based on the market and certain indicators, like valuations. The goal is to emphasize or de-emphasize the factors that are either more or less likely to outperform the market.
The biggest mistake investors can make with factor investing is to assume that all similarly named factor or smart beta funds are the same, Nestor says. But how the factors correlate with one another and influence the fund’s underlying investments will affect your portfolio’s diversification.
Know the pitfalls. An investor who’s new to factor-based investing should understand it’s a risky strategy. “A factor is essentially a variable that’s been shown to provide higher returns over time,” D’Auria says. Additional return comes with the assumption of additional risk.
For example, value stocks have tended to outperform growth stocks, which are higher priced, but why? “It may be at least in part because value stocks are riskier than growth stocks, meaning they have a lower price for a reason,” D’Auria says. Loading up on value stocks may make your portfolio less able to weather the bad times. “Moreover, factor strategies all assume the risk of tracking error to the benchmark, meaning you may not even get as high a return as the basic indexes you’re familiar with, such as the Standard and Poor’s 500 index.”
[See: 10 Ways for Investors to Buy the Market.]
Attempting to chase performance with factors can be just as dangerous as not understanding risk, especially for investors who single out only one factor. DeMaso says these investors need to consider why a factor is designed to outperform over time rather than look at how it’s performed the last few years. They also should understand how the factor’s performance meets their investment objectives. “Know why you own the fund and how it fits into your overall plan.”
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Diversify a Portfolio With Factor-Based Investing originally appeared on usnews.com
