How to Implement a Factor-Based Portfolio.
As a professional investment strategist, I think of the end of the year as Silly Season.
So many firms roll out their chief strategists and make predictions. Just for fun, in my next article, I'll compare the 2017 predictions to the 2016 predictions. What happened with 2016 predictions? Were they successful? Some yes, some no. What might we learn from that?
As Donald Rumsfeld famously said, there are known unknowns, and then there are unknown unknowns. Some things about the markets and the economy are predictable, but others--often the most important things--are not. Innovation is unpredictable, for instance, and it is a huge game-changer for the markets. It would fall into the known unknown category. And then there are the unknown unknowns, the black swans that can devastate markets--or spawn explosive growth. Who knows?
As factor-based investors, we look to what's predictable, based on decades of academic research. Many, many studies have shown that outperformance--alpha--can, to a great extent, be quantified, and characterized by certain characteristics of stocks, called factors. At my firm, Efficient Advisors, we use four of the most dominant factors to guide our portfolio construction approach. We start by trying to capture the global market at large, as inexpensively as possible, and then we adjust our weightings to reflect those factors that we believe will create outperformance. We overweight small cap and value stocks; we overweight stocks of highly profitable firms and stocks with positive momentum.
Steps to a Factor Portfolio
Out of the starting gate, the most inexpensive way to capture market performance is with a global, market-cap-weighted portfolio. This may be the most plain-vanilla way to invest today. Next, we have to decide: to what degree do we want to look different? This is where we - and the advisor - can add value.
There are two ways a factor investor can add value: the degree to which you hold more-risky and less-risky assets (i.e., asset allocation) and the degree of factor-tilting you embrace within broad asset classes. This means small and value in stocks, for example, and duration and credit-quality in fixed income. Each of these multi-faceted decisions have portfolio implications that need to be considered.
Asset allocation is the most obvious and familiar. Here, our approach centers on offering a range of portfolios to meet the needs of investors with varied risk/return objectives and time horizons.
What to Tilt?
Next come the factors--you could almost think of them as an overlay. We believe in presenting advisors with several ways to implement them, with varying degrees of alignment. We want to give advisors flexibility, because there are going to be times that factor exposure may not look like the best approach.
How much do advisors think they can look different from the market and still keep their clients committed? We don't want their clients to be muttering about going to cash.
We offer advisors three basic options within our factor framework, which differ in the degree of factor tilt. Our Core portfolios are mildly tilted; our Factor portfolios are more moderately tilted; and our Factor Plus portfolios have the strongest factor orientation. We then help advisors align their value proposition and talking points to clients with whichever of these implementation options resonates most strongly with them.
How Much of a Tilt?
A primary differentiator is how much of a factor tilt you think is appropriate for your clients. Most managers, including Loring Ward and Symmetry, two popular outsourcers that embrace factor-based investing, have a moderate degree of tilt. Matson Money takes a more aggressive tilt in their portfolios, which can make them look very different from the market at times.
I personally think that moderately tilted portfolios make the most sense over time. To me, they're the Goldilocks solution: distinct enough to outperform over time, but not so different from the market that you'd have a tough time keeping clients in their seats when the market goes against you. Whereas with the strongly tilted portfolios, some clients will wonder, "Why am I doing this instead of the S&P?"
How Long to Tilt?
If you look at factor portfolios over time (see chart), their likelihood to outperform is extremely high. Over rolling 10-year periods from 1928 to 2015, small cap stocks beat large cap stocks 72% of the time. During the same period, value stocks beat growth stocks 88% of the time. Over rolling 10-year periods from 1963 to 2015, high-profitability stocks beat low-profitability stocks 100% of the time. (Yes, there were some briefer periods where low-profitability stocks won.)
As always with investing, one of the primary considerations is your clients' behavior. We've been conditioned to look for rapid results--too many people are investing on internet time.
Try this thought experiment: Imagine you bought into a factor portfolio with a small cap/value tilt in 1997. The tech bubble starts inflating and all the appreciation is in large-cap growth; from the mid-1990s to about March of 2000, that was about all you should own. Would you have been able to stay committed to a fact0r-based approach? Because if you extend your time horizon by just a couple of years--let's say, 1997-2003--a small-cap/value-oriented portfolio was exactly the right thing to own. But if you can only give a factor strategy two years to succeed, you run the risk of being whipsawed. The market has a way of teaching hard lessons that way.
I don't like to equate investing with gambling but let's talk roulette. The wheel is 50% red and 50% black, so there's no advantage to systematically favoring one over the other. But what if one night the wheel were 70% black? You'd bet black all night long, regardless of results of a couple of spins.
There's a similar logic behind factor-investing - the goal is to systematically increase your odds of long-term success. If you, the advisor, are committed to the approach, patient and able to discipline your clients, you are putting the odds in your favor. It's not guaranteed, but the evidence would indicate that it's likely.
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|Date:||Nov 14, 2016|
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