Back to basics on factor investing

Factor investing is a style of management that aims to harvest the common traits of a group or basket of securities that helps inform their risk and return potential.

“When we talk about factors, we’re really talking about common characteristics that securities, such as stocks or bonds, share,” says Mo Haghbin, chief operating officer of investment solutions at Invesco, referring to characteristics such as value or size.

Read: Factor investing strategies becoming more popular for fixed income: survey

Dividing securities up by factor also allows investors to better understand their risks, achieve better diversification and focus on the factors they specifically want to target, says Samantha Cleyn, principal and senior investment consultant at Mercer Global Investments Inc.

“We talk about factors being broad, persistent drivers of return, so there’s a lot of academic research that supports that — if you tilt your portfolio towards value or to momentum, over long periods of time, these factors add value. And it also gives you greater transparency and control.”

Factor investing has been used for decades in the institutional space, but Haghbin says adoption rates are continuing to rise. And Cleyn notes most plan sponsors and institutional investors are cognizant of the factors they’re exposed to within their portfolios, even if they don’t overtly use a factor strategy. “Especially so in their equity portfolios, but more and more, there’s going to be an emphasis within fixed income portfolios and within hedge fund portfolios and other asset classes going forward as well.”

Read: Factor investing the ‘next evolution post-equities’ as allocations rise

Some of Canada’s more forward-thinking plans are looking at factors a bit differently, developing alternative frameworks to look at factors first and asset classes second when it comes to building their asset allocation, she adds. “So very much like a risk budget or a risk balanced strategy. They’re looking at: ‘What risks do we want to take on? How much credit? How much interest rate risk? How much inflation risk?’ And then they’re almost reverse engineering an optimal portfolio asset allocation out of that.”

Turbulent times

During periods of economic volatility or market disruption, factors such as low volatility and quality have historically performed better, says Haghbin.

Investors, then, have the tools and the ability to implement any kind of exposure and scenario they may be planning for. “For example, with perfect hindsight, if an investor were thinking about getting more defensive in their portfolio, they could actually increase the weight of low volatility and quality factors, and actually target a much more defensive equity universe than just owning the market outright. When you think about factors in more pro-cyclical and defensive terms, you can actually bucket those factors in a way and build a portfolio based on what your current forecasted risk and return views are.”

By the numbers

45% of global institutional investors increased allocations to factors in the previous year.

65% of North American investors intend to increase their use of factors in the coming three years.

66% of all survey respondents said their factor allocations have met or exceeded expectations.

Among specific factors, yield/carry was considered the top factor by 64% of investors, followed by liquidity (54%), value (46%) and quality (42%).

Source: Invesco survey, 2019

One of Cleyn’s takeaways from the current financial crisis is that she wouldn’t have expected growth and momentum as factors to perform as well as they have. “The part of the market that’s very expensive at the moment, that’s been driven up over the last many years, growth has been a top-performing factor; it’s very expensive. And I would have thought, if we went through a period of market correction, you’d see the more expensive names sell off. But the nuance with a virus like coronavirus is that it’s effectively impacting traditional brick-and-mortar retailers [and] the ability to leave one’s house, so a beneficiary of all of that is digital technologies, e-commerce, etc., which have been the sectors that have performed exceptionally well.”

Read: Factor investing expected to rise over next five years: report

These sub-sectors, containing many examples of growth and momentum stocks, are also proving to be the most resilient, she adds. “You might have built a portfolio where you wanted to have more diversified factor exposure. . . . You need to be cognizant of other factors you might be exposed to, and ultimately aim for a diversification of factors exposure, so you create an all-weather portfolio that should perform well, no matter what market environment you’re in.”

Jennifer Paterson is the editor of Benefits Canada.