Factor investing series

Building outcome-orientated factor portfolios

| 21 June 2018

Satrix factor series: Practical applications in factor investing

Part 9/10: Building outcome-orientated factor portfolios

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 ninth in our series of articles aimed at discussing practical ways to employ the power of factor investing. The previous article discussed an optimal approach to blending factors exposures, called multi-factor portfolio construction.

In this article, we further extend the conversation of employing multi-factor portfolios, but 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 through employing various combinations of underlying factor exposures.

In earlier articles in this series, we discussed how to formulate both ‘blended’ and multi-factor portfolios. However, both illustrations of those expressions were tailored toward a balanced, or diversified investment outcome. The strength of factor investing allows an investor to build bespoke solutions to cater for a variety of risk and return outcomes. For example, should a client seek a more defensive orientated portfolio, factor exposures could be custom built to serve this requirement.

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

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.

By combining certain factors, we are able to construct specific risk and return outcomes:

1 ) Pure defensive portfolio: This portfolio provides compelling protection to clients who are averse to deep drawdowns, however 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, while the latter through exposure to quality.

2 ) 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.

3 ) 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.

4 ) 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 is incumbent on the advisor or consultant to understand these needs, as well as the range of strategies which will optimally fulfil these needs. 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.

In our next and final part of the series, we discuss building factor portfolios using risk-based allocation

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