How Does Factor Investing Stack Up to Traditional Methods?

Now that we have a glimpse as to what factors can uncover, the next and final unknown is whether or not factor investing can serve as a value-add in portfolios. To answer this we compare and contrast traditional asset class portfolios with factor-based portfolios under four well-known investment strategies: equal-weight, minimum variance (lowest risk portfolio), maximum Sharpe ratio (highest expected risk-adjusted return portfolio), and risk parity (equal risk contribution portfolio).

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The benchmark is a customized index representative of MSCI ACWI.

What do the factors indicate about the key drivers of risk for each portfolio? Looking at the underlying factor exposures over time, we find again the beta factor is the largest driver of risk and other risk factors offset volatility incrementally. For all factor allocation versions in each strategy, risk is lower than its asset allocation counterpart, and it is also more evenly distributed across all factor exposures.

Key Takeaway – Factor Investing Is Here to Stay

Traditional asset allocation methods are geared toward emphasizing the beta factor and do little to diversify risk across other factors. This lack of diversification can limit the amount of risk reduction achieved and thus cap the amount of risk-adjusted return generated. Factors provide a targeted way to diversify risk, but more importantly they ensure meaningful risk reductions that can then deliver higher risk-adjusted returns.

Simply put, factors (and hence factor ETFs) can have a more meaningful risk-management impact in the pursuit of higher risk-adjusted returns than leveraging traditional asset classes (or market-cap weighted ETFs). Factor investing is an innovative re-think in how advisors and investors conceive their portfolios, providing a clearer focus on risk. We believe factors and factor investing will not fade as a short-term fad – instead, factors will become the future of portfolio selection by providing a clearer sense of what it means to truly be balanced for the long haul.

 

Joe Smith, CFA, is a Senior Market Strategist at CLS Investments, a participant in the ETF Strategist Channel.

 

This information is prepared for general information only.  Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such.  All opinions expressed herein are subject to change without notice. The graphs and charts contained in this work are for informational purposes only.  No graph or chart should be regarded as a guide to investing.