Factor investing series

Addressing unintended factor tilts

| 7 July 2017

Satrix factor series: “Practical applications of factor investing”

Part 2/10: Portfolio completion: addressing unintended factor tilts

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 second in our series of articles aimed at discussing practical ways to employ the power of factor investing. In the first application, we empowered the investor to diagnose their existing portfolio into factor exposures.  This application represents the next logical step: doing something about those factor exposures. This concept is typically referred to as a ‘portfolio completion’ exercise.

As the word suggests, portfolio completion is the exercise of adding or reducing specific exposures to your portfolio to fill a gap and achieve a targeted portfolio strategy. This application usually involves only a minor allocation to a factor, but is vitally important to address the client’s specific needs appropriately.

Let’s take an example of an equity value manager. After examining the portfolio’s factor exposures relative to the benchmark, we observe a significant underweight in the profitability factor exposure (see Figure 1).

Figure 1: Portfolio completion – adding a Quality factor to neutralise unintended tilts

Since most factors are not free from exposure to the others, it is likely that while trying to gain exposure to certain targeted exposures, other undesired factor exposures may creep in. And while perfectly disentangling these factors is not always a realistic objective, it would make sense to at least neutralise these unintended exposures. This should ensure that the portfolio achieves enhanced purity in the targeted exposures as well as mitigating any meaningful portfolio risks through unintended factor exposures.

In our example, while targeting a value strategy (particularly if shaped around a dividend yield factor), an inadvertent but significant under exposure in profitability is realised. Profitability, being a factor within the quality family of factors, has proven to be one of the most consistently strong factor signals in South Africa. As such, being meaningfully underexposed to this factor may compromise the premium added by the targeted value factor. The objective then is to neutralise the profitability exposure by adding a small allocation (20%) to quality, while not substantially diluting the intended value exposure. We achieved this in our example.

The key here is achieving the best balance between diluting the desired factor exposures and enhancing the diversification of the fund. This trade-off exists due to the completion portfolio (quality) often being somewhat negatively correlated with the existing portfolio (value). An additional benefit is also that through employing a completion portfolio, while achieving enhanced portfolio diversification, the investor can also leave the active manager to his/her own devices without constraining their process.

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

In our next part in the series, we will discuss using factors as a liquidity sleeve in your portfolio.

Watch this video on Portfolio completion: Addressing unintended factor tilts by head of portfolio solutions at Satrix, Jason Swartz.

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