A Simple Reason Why Advisors Should Use Factor-Based Asset Allocations

By Joe Smith, CFA, CLS Investments

Rethinking Your Asset Allocation Approach

Factors are changing the way investors think about asset allocation. The increasing popularity of ETFs using rules-based methodologies that hone in on factors to deviate from a market-cap index is driving more conversations than ever around factors and their impact on portfolios. But while factors hold significant potential, some financial advisors are not yet sold on their value-add.

At CLS Investments, we believe that there is a meaningful case for advisors to focus on factors, instead of sectors, countries, or regions, when making their asset allocation decisions. Factors are backed by a significant amount of  academic literature. More importantly, they can explain risk and returns in pretty much any portfolio.

This article focuses on one aspect of factors that is often misunderstood — the risk-adjusted nature of returns. Returns are at the heart of what’s important to investors, and if there is a value-add to making asset allocation decisions based on factors, the return element has to be there for investors to consider making the switch. Let’s take a look at how this shakes out.

Time to Crunch the Numbers

In order to evaluate factors as a means of building strong portfolios, we reviewed returns of primarily MSCI ACWI indexes since December 1995. We generally looked at equal-weighted mixes of global GICS sector indexes, global regional indexes (Russell 3000, MSCI EAFE, and MSCI Emerging Markets), and global factor indexes (MSCI ACWI Value-Weighted, Momentum, Minimum Volatility, Quality, and Small-Caps) as individual portfolios to compare relative to the MSCI ACWI.

We then calculated annualized excess returns and volatilities for each equal-weighted portfolio versus a measure for cash and determined their Sharpe ratios. Finally, we calculated risk-adjusted returns for each portfolio using the Modigliani-Modigliani measure and compared them to those of the MSCI ACWI.

Drumroll Please…

Do factors deliver some value-add? Based on our results: yes. Looking at all time frames going back to the end of 1995, we found that an equal-weighted mix of factors produces better excess risk-adjusted returns over time relative to a global equity benchmark. Surprisingly, we also found that taking an equal-weighted view toward focusing on sectors or regions does not yield tangible excess risk-adjusted returns relative to the MSCI ACWI.

A Simple Reason Why Advisors Should Use Factor-Based Asset Allocations 1
Sources: Morningstar Direct, MSCI, and FTSE/Russell. MSCI ACWI GICS Sectors, Russell 3000, MSCI EAFE, MSCI Emerging Markets, and MSCI ACWI Factor indexes used in analysis. Data is based on gross returns from December 1995 through November 2018.