Factor investing is gaining in popularity, with investors attracted by the enhanced returns, reduced risk and diversified exposure that factor investing offers at a time when investors are navigating a highly uncertain future.
In fact, the adoption of factor investing doubled in just three years, says Peter Weidner, Head of Factor Solutions at Wells Fargo Asset Management, at Satrix’s recent conference ‘The Future is Factor Investing’. This is according to a 2018 FTSE Russell Smart Beta survey, global adoption by asset owners of smart beta, another description of factor investing, increased to 48% in 2018 from 26% in 2015.
Weidner says surprisingly cost, usually a strong motivation for investing in systematically driven investment vehicles like index funds and exchange traded funds, is not the main reason for the growing interest in factor investing. Instead the benefits are perceived to be multi-dimensional, with the top three seen to be return enhancement, risk reduction and improved diversification. Cost savings follow as number four on the list according to the survey.
Factor investing is an investment strategy that seeks to enhance returns by choosing investments based on certain attributes or factors. The most commonly identified factors include value, momentum, quality, low volatility and small size.
Factor investing became a feature of the investment environment as investors’ understanding of the capital asset pricing model (CAPM) evolved over time. Before CAPM was introduced, investment performance was understood to be a total return that comprised of capital appreciation and dividends. CAPM divided this further into the investment returns generated as a result of the market (beta) and those by the skill of the asset manager (alpha).
The current thinking is that investment returns can be distinguished by the proportion generated by the market (beta), the more recently recognized components that can be directly attributable to specific factors that drive performance and, finally, by the excess returns achieved through active management (alpha). This is reflected in the diagram below.
Historically, there is evidence that factor investing has enhanced returns and reduced risk, says Weidner. Analysis done by Analytic Investors captures the relative risk-adjusted performance of the most common factors versus the US equity market between 1967 and 2018. They find that investors would have achieved higher returns investing on the basis of factors and that in some instances these returns would have been generated at lower risk levels than the market portfolio too.
How should investors access the returns generated by different factors? Weidner says you can invest in a fund that gives you exposure to a single factor but this could expose you to unintended tilts. For instance, the graph below shows that if you invest in an ETF that gives you exposure to the value factor, you would be exposed to other factors, for instance the portfolio would have a negative tilt towards the momentum, quality and low volatility and a positive tilt towards the small size factor.
You can reduce these unintended tilts by investing in different factor sub-portfolios, which historically could have improved your investment outcome by 35%. However, opting to invest in a multi-factor portfolio that integrates all factors optimally historically resulted in a 73% improvement in risk-adjusted returns, as measured by the Sharpe ratio.
The Satrix Factor Tool
This highlights how useful it is to understand what different factors contribute to a portfolio’s returns over time. To harness this information, Satrix developed the Satrix Factor Tool, which enables you to identify how a portfolio is structured through a factor lens.
It is a powerful tool that enables you to choose funds on the basis of their factor exposures and can also confirm whether a fund’s positioning is consistent with what it says it does, says Satrix CIO Kingsley Williams. For instance, a value fund should have a strong value factor exposure and the tool enables you to determine whether the portfolio is structured as such on a detailed factor-basis.
In addition, the tool can identify unintended factor exposures that may offset other factors you are seeking exposure to, and which may present performance headwinds for what your portfolio is trying to achieve.
The benefit of the insights offered by the Satrix Factor Tool is that you can better understand the role each fund is playing in your portfolio and make better informed investment decisions.