As we consider the role factors can play in helping to diversify our investment portfolios, investors can turn to smart beta or factor-based exchange traded fund strategies to better navigate through volatility, mitigate concentration risk, and more.
In the recent webcast, Can Factor-Based Strategies Help Mitigate Volatility?, Craig Lazzara, managing director and core product management at S&P Dow Jones Indices, explained that factor, strategic beta, or smart beta ETFs follow customized index-based fund strategies focus on specific patterns or characteristics in the market to in a bid to better “indicize” traditional active strategies and they are typically not capitalization-weighted.
“Think of a factor as an attribute with which excess returns are associated,” Lazzara said.
The factor indices provide cheap, transparent, and reliable factor exposure, and they still require active managers to add value by stock selection.
For example, Lazzara noted that defensive factor-based indices deliver protection in falling markets and participation in rising markets, but neither protection nor participation is perfect. In addition, defensive investing suggests the existence of a low volatility or low-risk factor of return, which challenges what we think we know about the relationship between risk and return.
Lazzara pointed to something like the S&P 500 Low Volatility Index as a means to help investors remain defensive. The low-vol index helps increase return for the same level of risk, reduces risk at the same level of return, and helps investors reduce their bond exposure.
On the other hand, Lazzara added that the S&P 500 Equal Weight Index could help contribute to higher long-term returns, but it comes with a greater risk. Nonetheless, investors can combine both a defensive S&P 500 Low Volatility Index exposure with an S&P 500 Equal Weight Index position to enhance returns and better manage overall risk exposures.
Nick Kalivas, head of factor and core equity product strategy at Invesco, also highlighted findings from Invesco’s 7th annual Global Factor Study, which focused on financial advisory and intermediary firms. The study was focused on understanding the growth in factor investing, investor experiences, and implementation.
According to the factor study, market turmoil highlights the value of factors in managing risk. ESG performance challenges drive interest in applying a factor approach to ESG. The end of the fixed income bull market sees investors looking to factors for new sources or returns. Additionally, the accelerating rate of change in markets highlights the benefits of tactical tilting to a long-term diversified multi-factor approach.
Comparing performances year-over-year, Kalivas noted that the spiking inflation and rising interest rates have led to a revaluation placed on growth. Consequently, a multi-factor approach was the norm for implementation, with value, low volatility, quality, and momentum as the most targeted factors.
Kalivas pointed out that confidence in factors increased over time relative to the first implementation of factor investing, which suggests that financial advisors and investors are becoming more acquainted with the investment methodology and are comfortable with executing more complex strategies. About 55% of respondents indicated factors were used for risk and performance management compared to 28% four years ago. Nearly two-thirds of respondents said factors helped manage market volatility and increased their faith in factor investing.
The implementation of factors has also steadily become more tactical over the past seven years moving beyond a “set and forget” model, according to the study results. About 80% of responders say they adjusted factor weights through time, and the short-term approach is more common among retail investors. When it comes to selecting factors, factor purity and clearly outlined methodology are key criteria for factor product use, but performance ranks high too. On the other hand, external ratings are the least important.
Niko Finnigan, partner and net worth advisor at Delta Wealth Advisors, argued that factor implementation has helped loss aversion where losses feel twice as bad as an equivalent gain. He advised investors to educate themselves about the potential for divergence in performances among the various factors and educate themselves about sustained underperformance in specific factor-based strategies.
Financial advisors who are interested in learning more about factor investment strategies can watch the webcast here on demand.