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Video · 04.04.23

Factor Investing in the Real World

Investors use factor‑based strategies in their portfolios to potentially improve risk‑adjusted performance that can lead to real differences in portfolio outcomes.
  • Factor Investing
  • Portfolio Construction
Key points
What this is
We answer common questions we hear from pension funds, defined contribution sponsors and other institutional clients on factor‑based investing.
Why it matters
The smart addition of factor exposure to address real world problems can meaningfully change the complexion of portfolios.
Where it's going
Investors use factor‑based strategies in their portfolios to potentially improve risk‑adjusted performance that can lead to real differences in portfolio outcomes.

It's fair to say that many investors see as a way to enhance returns relative to a cap weighted benchmark. However, factors can do so much more to help manage risk and return. I get a lot of questions from clients about factor investing. One of them is: My portfolio is underperforming, what can I do? Well, we worked with a pension fund with a large passive allocation and a to fundamental active managers. This resulted in an expected portfolio of about 90 basis points. In their effort to improve the portfolio, we made equal allocations to two factors initially and the pension fund tactically adjusted them. The expected alpha and rose while fell. Alpha nearly doubled. We believe that with factors you can control your active risk without such a heavy reliance on passive strategies and you don't have to lose alpha to do so.


Another question I get is: I already have factor exposure to growth and , why do my portfolio returns look like the benchmark? To illustrate, a initially had a lineup of large cap value, passive equity, and large cap growth exposures. Looking at the aggregate portfolio, we found their only material factor exposure was to the large cap factor, which was negatively compensated. To correct the problem, the DC plan sponsor added a combined and value factor-based strategy. This neutralized the size factor and added meaningful exposure to the value and quality factors. In other words, they eliminated one negatively compensated factor in exchange for two positively compensated factors. The expected alpha and information ratio rose. So what's the key takeaway here? The smart addition a factor exposure can meaningfully change the complexion of your portfolio.


Finally, we've worked with many pension funds and they often ask: How can I match my factor exposures to my various funding levels? For example, if the funded status is about 80%, the low funding could trigger regulatory action. We recommended a risk mitigation strategy using the factor. However, if the funded status moves to about 90%, the pension can take on more risk to try to close that funding gap. We recommended a more performance- oriented factor strategy emphasizing value, size and quality. Once a pension gets to funded status, a more moderate approach is useful. Equity exposure should be sufficient to offset growth and participant liabilities. But with no funding gap there's no longer a need to take as much risk. A combination of low volatility, value and other factors may work well here.

Main Point

More than risk and return

Well-designed factor-based strategies on their own can help investors get the most out of the risks they take, but they may add even more value as portfolio construction tools. Investors should analyze their portfolios to better understand their factor exposure and determine whether the addition of factor-based strategies will enhance risk-adjusted performance.

Portfolio Construction

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Michael Hunstad, Ph.D.

Deputy Chief Investment Officer & Chief Investment Officer of Global Equities

Michael Hunstad is deputy chief investment officer and chief investment officer of global equities for Northern Trust Asset Management. Michael is a member of the Asset Management Executive Group and has oversight of all equity portfolio management, research and trading activities including quantitative, index and tax-advantaged strategies. Additionally, he assists with the development of investment vision, strategy portfolio construction and risk management framework for the firm’s broad investment platform.

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