Building outcome orientated factor portfolios

Part 9/10: Factor investing: what it is and how to use it

Building outcome orientated factor portfolios

Client level of adoption/allocation:

Earlier in this series, we discussed how to formulate both ‘blended’ and multi-factor portfolios. Both illustrations of these two types of portfolios were tailored toward a balanced or diversified investment outcome. But factor investing can also be used to build cautious or aggressive equity portfolios and every risk profile in between.

The strength of factor investing allows an investor to build bespoke solutions to cater for a variety of risk and return outcomes.

In this article we focus on an approach to build outcome-orientated multi-factor portfolios. These portfolios are designed to deliver, with high predictability, a specific risk and return outcome by using various combinations of underlying factor exposures.

Figure 1: Risk versus return of individual and multi-factor portfolios (2001 to 2016)

For illustration purposes, we constructed multi-factor portfolios from every combination of four well-known single factor portfolios, namely: momentum, value, quality and low volatility. We equally weighted the factor scores to create each multi-factor portfolio, and set all tracking errors to 5% to ensure reasonable investability.

• Pure defensive portfolio: This portfolio provides compelling protection to clients who are averse to deep drawdowns but still require cautious exposure to the equity risk premium during an upswing post a deep correction. The former is provided by exposure to low volatility and the latter through exposure to quality.

• Dynamic defensive portfolio: This portfolio juxtaposes the most defensive factor exposure, low volatility, to that of the most cyclical or aggressive factor, of momentum. On a risk-adjusted return basis, this multi-factor portfolio has one of the best historic outcomes, as the interaction between stocks with a robust performance trend and stocks with a lower volatility is evidently very powerful.

• Balanced portfolio: This portfolio balances exposures across all factors and essentially offers a turnkey solution to an investor seeking a complete, diversified equity portfolio to outperform the market through the cycle.

• Dynamic portfolio: This portfolio provides clients with a more cautious version of an aggressive momentum factor, by complementing the momentum portfolio with quality This addition does not compromise the prospective premium meaningfully, but doesn’t substantially lower the volatility of the multi-factor portfolio.

Ultimately, all investment offerings need to cater for and deliver on a client’s needs. To this end, it’s important that advisers understand these needs, as well as the range of strategies which will optimally fulfil them. We believe that multi-factor portfolios can be effortlessly employed during a comprehensive outcomes-based investment approach, as the risk and return outcomes are largely reliable and predictable relative to other equity alternatives.

For more information on this topic, or for additional detail on our analysis, please feel free to contact us directly.