Factor investing series

Blending factors using strategic allocations

| 2 September 2017

Satrix factor series: “Practical applications of factor investing”

Part 4/10: Blending factors using strategic allocations

Client level of adoption/allocation:

Factor investing has the ability to empower consultants, multi-managers and advisors to build client portfolios simply and efficiently.

From 1) the transparent manner in which factor portfolios are systematically constructed, to 2) the capability of building tailored investment outcomes with greater diversification and predictability, to 3) the low fees, to 4) the reliability in consistently delivering a specific investment philosophy. Factor investing is beginning to revolutionise the investment industry.

While the potential impact of factor investing is transforming in nature, the level of adoption by clients varies by degree of simplicity, from ‘not allocating’ to ‘sophisticated allocation’. In this series we aim to highlight all applications of factor investing across this continuum.

This article is the fourth in our series of articles aimed at discussing practical ways to employ the power of factor investing. In our previous article, we discussed building a liquidity sleeve around your portfolio to aid liquidity management.

In this article, we discuss blending factors with strategic allocations to each factor in order to achieve a diversified equity portfolio, while still exposing your portfolio to each factor’s long-term return premium.

Despite the fact that many single-factor strategies have empirically earned a long run premium to the market, each of these factors have suffered periods of substantial underperformance under certain market conditions, due to their specific cyclicality. As such, the risk of being exposed to a single factor is significant and often not diversifiable.

Blending a number of uncorrelated factors produces more diversified portfolios, with this blended portfolio mitigating the peculiarities associated with each individual factor, and producing return outcomes that are substantially more reliable and predictable.

Figure 1: 3 year distribution of returns for Value versus a blend of Value, Quality and Momentum

One contentious position on blending factors is: do you dynamically or tactically adjust your factor allocations to take advantage of cyclical performance, or do you employ static allocations through time and rebalance periodically? We have taken the latter view, arguing that timing factor performance is enormously challenging, and that the incremental impact of simply using static allocations will pay off over time. We do not discourage clients from employing factor timing – at the margin – based on either valuations or economic cycles. , However employing this approach would require a specific skill set and expertise. In our view, strategic allocations to factors serve the requirements of a blended factor portfolio best.

When blending single factors, due consideration needs to be given to which factors are included in the blend in so far as the role that both the overall portfolio should play as well as the single factors within the blend. In Table 1 below, we illustrate our house-view equity blend of domestic factors which utilises a naive equal weighted approach2 , and is made up of our four single factor building block portfolios.

Table 1: Factor allocations to Satrix Smartcore (equity factor blend product)

Blending single-factor portfolios has great value and application to investors who appreciate diversification among factors, as well as the transparency and predictability of performance between the factor building blocks. These blended factor portfolios tend also to deliver higher risk-adjusted returns than the broad equity benchmarks, with a lower tracking error than most single-factor strategies.

For more information on this topic please feel free to contact us directly.

In our next part in the series, we will discuss the application of adding a blended factor equity portfolio to a multi-asset portfolio.

Watch this video for blending factors using strategic allocations by head of portfolio solutions at Satrix, Jason Swartz.

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In a later article, we discuss more sophisticated ways to weight factor portfolios.