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Factor-based strategies have become increasingly popular in recent years. But how to implement them in practice still remains a puzzle for many newcomers. Determining the proportion of a portfolio that should be allocated to factors is a key challenge.
Factor based strategies have been gaining traction over the past decade. But while awareness as to the benefits of targeting academically-documented premiums has considerably improved, these investment solutions still remain a relatively novel and unusual approach to investment, both in equity and fixed income markets.
As a result, explicitly allocating to factors also remains a very delicate decision for many individual and professional investors. Doing so might be frowned upon, if they work for an organization such as an insurance company or a pension fund for example. This is especially true if the potential benefits of factor investing are not properly understood by other stakeholders.
Investors could also run into significant practical difficulties in terms of business organization. For a bank employing a large number investment advisors and offering traditional active funds, for example, switching from to pure active investing in factors might be a big step. And it might also be just as difficult for an established institutional asset owner to restructure its portfolios, and abandon its classic asset class based allocation framework in order to embrace factor based investment approaches.
In this context, determining how and how much of a portfolio should be allocated to factors is – not surprisingly – often seen as a critical decision, when considering factor based strategies for the first time. A FTSE Russell survey carried out in 2016 actually revealed that the proportion of a portfolio that should be allocated to factors ranked sixth among investors’ concerns, when they were faced with the task of factor oriented allocation.
Unfortunately, there is no easy answer to this question. As illustrated in the previous article of this series, which is dedicated to the major challenges associated with factor based allocation, there is no silver bullet for benefiting from well-established premiums. Depending on their needs and priorities, in terms of factor exposures or flexibility with regard to a reference index, for example, investors will able to choose from a wide array of factor based products and implementation possibilities*.
To determine how much of a portfolio should be explicitly be allocated to factors, investors can start by asking themselves whether or not they believe in the added value of traditional active management. Factor investing is based on the existence of a number of premiums, which can be systematically exploited through rules based stock or bond selection processes. As a result, it is often considered as a third alternative to purely passive and traditional active management.
At least one-third of a portfolio would have to be allocated to factors in order to have any meaningful impact
Among asset owners who believe it makes sense to include active management in their portfolio, an allocation of one-third of the portfolio each to active and passive strategies and one-third to factor based products is a popular approach. Generally speaking, at least one-third of a portfolio would have to be allocated to factors, in order to have any meaningful impact − unless the investor is only looking to get their feet wet before eventually aiming to allocate a higher proportion later.
Conversely, clients who see market cap-weighted passive investing as the starting point but, at the same time, want to benefit from factor tilts, can consider enhanced indexing. These strategies are designed to capture the market return and, in addition, provide access to established factor premiums. In this case, the passive portfolio could be entirely reallocated to enhanced indexing, while keeping tracking error at very low levels, say around 1%.
In between these two approaches, there exist an infinite number of options for investors to choose from. Different factor based solutions can be combined, but they also work very well in conjunction with traditional fundamental strategies. For example, low volatility strategies can be combined with benchmark-driven products or high dividend funds, in order to generate diversification benefits thanks to their less volatile return pattern**.
But no matter what their approach may be, investors should not forget to closely monitor their overall factor exposures, before and after allocation. As explained in a previous article of this series, investors must ensure they are fully aware of their exposure to the different premiums. For example, if a client’s holdings already have an unintentionally significant tilt, a factor strategy targeting a lower explicit weight for that specific factor may be the best choice.
That’s why in a recent interview with Robeco, Cambridge professor of finance Elroy Dimson insisted that asset owners should at least monitor factor exposures. “Even conventional investors, not just the very sophisticated, quant-oriented ones, need to assess and to take into account their exposure to different sources of risk,” he said.
Dedicated tools, that enable quantitative factor exposure and performance attribution analysis, are available in the market, and the subject has been covered extensively in the academic literature***.