The wealth of easily accessible data available to investors means factor-based investing is an increasingly important tool, according to an AGFiQ senior vice president.
Mark Stacey, head of portfolio management and co-chief investment officer, said that while the approach has been around a long time, the financial crash of 2008 was a brutal wake-up call as to how people’s portfolios could inadvertently be correlated to factors.
Stacey said: “One of the things that people felt going into 2008 was that they understood their portfolios and the risk and rewards to it, but they quickly realised that the correlations or unintended consequences and bets that they made became pretty relevant, and they were cognizant of those.
“You thought something wasn’t correlated to a factor and it was, and so people started to view their portfolios not just as a bundle of stocks but they started to think about them from a factor perspective and factor exposure.
“I think that came first from a risk perspective and now you’re turning to the fact it’s not just about risk, it can also be a long-term generator of outperformance.”
The foundations of factor investing are based around value, size (small-cap over large-cap), quality, momentum and volatility. Stacey said the theory is rooted in extensive testing from an academic and professional industry perspective and the diversification potential is compelling.
He said: “They may not all work at the same time, but when you put them together, that actually helps you lower your overall portfolio risk and you can diversify across factors, which helps as well.
“Each of them are slightly different but they each provide long-term outperformance so you’re getting exposure to long-term factors that work all the time. But a lot of people want to try to time stock factors, sectors and industries – this provides exposure but you get it from a factor perspective.
“It’s been well-founded, well-tested and because of all the data, it just doesn’t work in one set of asset classes, it works in multiple asset classes – that’s why you get the advantage of being called a factor because it’s not just in one market, it’s across all markets. There’s a difference between a theme and a factor.”
Stacey concedes that, like other areas of investing, there can be some crowding with factors subject to periods of underperformance, although he emphasises that the approach is ultimately based on successful long-term returns.
There is also the issue of complexity and time, with a factor-based approach requiring more depth than your standard 60-40 portfolio mix. Often, he said, getting two factors from an index and calling it a portfolio is not enough.
He said: “I think the desire is to create portfolios that balance that opportunity and risk, so you’re not getting stocks all from one sector or one country, so you have to put it all together.
“One of the benefits of factor based is it works very well for someone who can take a disciplined and repeatable transparent investment process. If you have factor-based approach you tend be pretty disciplined because you know it’s going to lead to the outcomes and returns you are looking for.”
Stacey warned that changing your delivery and deviating from the plan will not work. He said: “There is an element of consistency that has to be delivered if you are going to take this type of approach.”
Smart-beta ETFs: bar has been raised for active managers
Steering clients away from recency bias
More market talk: