Going All In with Factors
Even in traditional portfolios, research we have seen shows that most of the variation of returns come from allocations and not manager or vehicle selection. So choosing the right factors targeted to your specific goals is very important. With this in mind, there are three ways to approach this: equal- weighted factors, equal-weighted active risk and equal-weighted absolute risk.
Equal-weighted factors is the most simplistic approach to factor investing and it happens to be very popular and off-the-shelf factor products, often called smart beta. Equal weighting simply involves making equal allocations to factors. Clearly some advantages to this approach: it's easy, it’s transparent and it can utilize a variety of managers in the process. However, because factors have different volatilities, one major disadvantage is that actual portfolio risk can be skewed to just one or two factors, which represents a major risk to the overall portfolio.
The second design is the equal-weighted active risk approach, meaning that each factor contributes equally to portfolio . On the surface this seems to be very logical and consistent with standard approaches on risk parity. It also works well for investors that do not have a view on the attractiveness the various factors and instead want to equally spread their factor risk across the portfolio. However, individual factor active risks can be highly unstable and a portfolio can experience rapidly changing allocations to risk factors over time, which as a result causes higher turnover and fees.
Finally, we look at the equal-weighted absolute-risk approach, which involves weighting factors so that they equally contribute to the total risk of the portfolio. The key benefit of this approach is that absolute risk is much more stable than active risk for tracking error. One downside is that the factor contribution to active risk varies over time, which may make it harder to track given benchmarks. But the result is a more stable portfolio, fewer transactions and lower overall fees than the active-risk approach.
Tracking error is the difference in performance between a portfolio and its benchmark, often used to determine the degree of active management of an investment strategy.
Factor-based strategies invest in securities that historically have outperformed the broad market over time, in particular those with quality, low-volatility, value, high-dividend, small-size and momentum characteristics.
The notional value is the total value of a position, often used with derivative contracts.
Aligning Factor Portfolios with Your Goals
Going all-in with factors means understanding the trade-offs of the different factor-implementation approaches and how they support your investment objectives. These trade-offs affect portfolio management costs, how much each factor influences portfolio results, simplicity, transparency, and how well the portfolio returns track a benchmark.
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.Read Bio
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