Factor-based strategies can help investors build better diversified portfolios. Third article of a series on how factors can help investors achieve specific goals.
Diversification is often said to be the only ‘free lunch’ for investors. And for centuries, asset owners have applied this principle by dividing their holdings across different asset classes. But the dramatic increase in correlations between asset classes during the market wobbles of the 2000s, especially during the global financial crisis, has started to cast doubt on the benefits of traditional diversification.
One of the key debates today in the financial industry is whether quantitative approaches to portfolio selection and construction are more effective than traditional ones, in particular in terms of diversification. For instance, the influential 2009 study1 on the Norwegian Oil Fund and factor investing showed that despite a seemingly diversified profile, the fund’s active returns had large exposure to systematic risks, mainly due to bottom-up decisions.
The quest for more robust diversification techniques has caused many investors to turn to factor investing. In fact, a recent FTSE Russell survey of asset owners found that improved diversification ranked third among the top investment goals that lead them to consider factor-based strategies
Contrary to traditional asset allocation, which often lacks scientific grounding, factor allocation is based on decades of robust empirical analysis. This research documents a number of significant, persistent and relatively uncorrelated risk-return patterns across financial markets. Investors can take advantage of these patterns and select securities with different risk-return characteristics to achieve better diversification.
A 2012 paper2 by Antti Ilmanen and Jared Kizer analyzing market data on a number of asset classes dating back to 1927 reported that diversification into and across factors has been much more effective in reducing portfolio volatility and market directionality than traditional asset class approaches. And while the authors acknowledged that long-short investing generates the most diversification benefits, which implies short-selling and leverage, they also found meaningful benefits in a long-only context.
More recently, in a research report3 initially prepared for Robeco, Kees Koedijk and Alfred Slager, from Tilburg University, and Philip Stork, from VU University Amsterdam, also looked at the degree to which diversification can be achieved using a factor-based approach instead of an asset-based one. They argued that diversification across factors has major benefits, as the correlation between factors such as value or momentum is much lower than between investment categories.
The diversification benefits of factor investing are also evidenced by the performance of Robeco’s Multi-Factor Equities strategy over time. Figure 1 shows the simulated performance of a multi-factor portfolio over the period 1988 through 2015. It also shows which of the four factors (value, momentum, low volatility and quality) targeted in our quantitative equity strategies outperformed in each year.
Ultimately, the result is a balanced and stable outperformance, compared to the broader market (grey area), with positive contributions from at least three factors in three out of four full calendar years.
Although the focus should remain on optimizing factor exposures to ensure diversification, the merits of investing in a broad and varied selection of securities should not be forgotten. Robeco’s in-house research shows that adding sector weight constraints to an unconstrained portfolio reduces concentration risk while not significantly altering returns, at least to a degree. At a certain point, however, concentration limits start to have a negative effect on performance.
This implies that an optimal level of concentration exists, and this should be taken into account by investors. Efficient factor strategies should therefore not only focus on finding the best factor exposure, but also prevent unintended geographic or sector biases, as well as undue concentration on some single securities or sub-segments of the financial markets. One way to ensure this is to establish strict but workable concentration rules, as this would lead to a varied selection of stocks or bonds while avoiding excessive sector and country tilts.
This series of articles aims to illustrate the wide variety of investment goals that can be achieved through factor-based strategies.
Read all of the articles:
The contents of this document have not been reviewed by the Securities and Futures Commission ("SFC") in Hong Kong. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. This document has been distributed by Robeco Hong Kong Limited (‘Robeco’). Robeco is regulated by the SFC in Hong Kong.
This document has been prepared on a confidential basis solely for the recipient and is for information purposes only. Any reproduction or distribution of this documentation, in whole or in part, or the disclosure of its contents, without the prior written consent of Robeco, is prohibited. By accepting this documentation, the recipient agrees to the foregoing
This document is intended to provide the reader with information on Robeco’s specific capabilities, but does not constitute a recommendation to buy or sell certain securities or investment products. Investment decisions should only be based on the relevant prospectus and on thorough financial, fiscal and legal advice. Please refer to the relevant offering documents for details including the risk factors before making any investment decisions.
The contents of this document are based upon sources of information believed to be reliable. This document is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.
Investment Involves risks. Historical returns are provided for illustrative purposes only and do not necessarily reflect Robeco’s expectations for the future. The value of your investments may fluctuate. Past performance is no indication of current or future performance.
Please read this information carefully.
This website is prepared and issued by Robeco Hong Kong Limited ("Robeco"), which is a corporation licensed by the Securities and Futures Commission in Hong Kong to engage in Type 1 (dealing in securities); Type 4 (advising in securities) and Type 9 (asset management) regulated activities. The Company does not hold client assets and is subject to the licensing condition that it shall seek the SFC’s prior approval before extending services at retail level. This website has not been reviewed by the Securities and Futures Commission or any regulatory authority in Hong Kong.
2. Important risk disclosures
2. Important risk disclosures Robeco Capital Growth Funds (“the Funds”) are distinguished by their respective specific investment policies or any other specific features. Please read carefully for the risks of the Funds:
3. Local legal and sales restrictions
The information contained in the Website is being provided for information purposes.
Neither information nor any opinion expressed on the Website constitutes a solicitation, an offer or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service. The information contained in the Website does not constitute investment advice or a recommendation and was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. An investment in a Robeco product should only be made after reading the related legal documents such as management regulations, prospectuses, most recent annual and semi-annual reports, which can be all be obtained free of charge at www.robeco.com/hk/en and at the Robeco Hong Kong office.
4. Use of the Website
The information is based on certain assumptions, information and conditions applicable at a certain time and may be subject to change at any time without notice. Robeco aims to provide accurate, complete and up-to-date information, obtained from sources of information believed to be reliable. Persons accessing the Website are responsible for their choice and use of the information.
5. Investment performance
No assurance can be given that the investment objective of any investment products will be achieved. No representation or promise as to the performance of any investment products or the return on an investment is made. The value of your investments may fluctuate. The value of the assets of Robeco investment products may also fluctuate as a result of the investment policy and/or the developments on the financial markets. Results obtained in the past are no guarantee for the future. Past performance, projection, or forecast included in this Website should not be taken as an indication or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. Fund performance figures are based on the month-end trading prices and are calculated on a total return basis with dividends reinvested. Return figures versus the benchmark show the investment management result before management and/or performance fees; the fund returns are with dividends reinvested and based on net asset values with prices and exchange rates of the valuation moment of the benchmark.
Investments involve risks. Past performance is not a guide to future performance. Potential investors should read the terms and conditions contained in the relevant offering documents and in particular the investment policies and the risk factors before any investment decision is made. Investors should ensure they fully understand the risks associated with the fund and should also consider their own investment objective and risk tolerance level. Investors are reminded that the value and income (if any) from shares of the fund may be volatile and could change substantially within a short period of time, and investors may not get back the amount they have invested in the fund. If in doubt, please seek independent financial and professional advice.
6. Third party websites
This website includes material from third parties or links to websites maintained by third parties some of which is supplied by companies that are not affiliated to Robeco. Following links to any other off-site pages or websites of third parties shall be at the own risk of the person following such link. Robeco has not reviewed any of the websites linked to or referred to by the Website and does not endorse or accept any responsibility for their content nor the products, services or other items offered through them. Robeco shall have no liability for any losses or damages arising from the use of or reliance on the information contained on websites of third parties, including, without limitation, any loss of profit or any other direct or indirect damage. Third party off-site pages or websites are provided for informational purposes only.
7. Limitation of liability
Robeco as well as (possible) other suppliers of information to the Website accept no responsibility for the contents of the Website or the information or recommendations contained herein, which moreover may be changed without notice.
Robeco assumes no responsibility for ensuring, and makes no warranty, that the functioning of the Website will be uninterrupted or error-free. Robeco assumes no responsibility for the consequences of e-mail messages regarding a Robeco (transaction) service, which either cannot be received or sent, are damaged, received or sent incorrectly, or not received or sent on time.
Neither will Robeco be liable for any loss or damage that may result from access to and use of the Website.
8. Intellectual property
All copyrights, patents, intellectual and other property, and licenses regarding the information on the Website are held and obtained by Robeco. These rights will not be passed to persons accessing this information.
10. Applicable law
The Website shall be governed by and construed in accordance with the laws of Hong Kong. All disputes arising out of or in connection with the Website shall be submitted to the exclusive jurisdiction of the courts of Hong Kong.