Making sense of factor investing
19 May 2017 | Portfolio construction
Commentary by Scott Pappas, an Australia-based investment analyst with Vanguard Investment Strategy Group.
Is factor-based investing just the latest fad in investing? Is it really a better form of indexing? How can we use it in a portfolio?
These are just some of the questions I hear from clients. The short answer is that factor-based investing is neither the latest fad nor a better form of indexing. It's simply a way to achieve risk, return, or income objectives that differ from those of the broad market.
Let's unpack these answers in a little bit more detail.
A venerable history
Factor-based investing has been around in different guises for some time now. Although it has only recently started attracting attention, it has been with us since the 1930s when a couple of academics – Benjamin Graham and David Dodd1 – introduced the concept of value investing. Their theory, in short, was that investors should focus on the shares of companies that are trading cheap relative to their fundamental value.
But factor-based investing also includes other techniques such as high dividend yield, or minimum-volatility investing. While these approaches are all quite different, they have some common characteristics.
First they are all actively managed approaches. Portfolios are deliberately tilted away from market-capitalisation weights in order to achieve a potential outcome – for example, higher income, higher returns or lower risk. Like any form of active management, the objective is to achieve a certain level of performance, but there is a degree of uncertainty around when or if this desired performance will eventuate.
Typically, factor-based funds are constructed using a series of rules that provide transparency and a consistent approach to investing. These commonalities are why we are now grouping these seemingly disparate strategies together under the common handle of factor-based investing.
So, factor-based investing is just a collective way to describe a range of active strategies that are based on transparent rules-based selection criteria.
However, the big question is, how should one use factor-based investing in a portfolio?
The first step is to have a clear objective in mind. Is the goal income, return, or risk? Different factor investments are designed for different outcomes, so having a clear goal is necessary to make a suitable choice.
Next, ask yourself how much active risk you are willing and able to take. Strategies like value, income or minimum-volatility investing can experience extended periods of underperformance. This can sometimes challenge even the most disciplined of investors. The percentage size of the allocation should be based on investor risk tolerance – getting this right can help investors stay the course during periods of poor performance. Getting it wrong can test an investor's conviction.
Setting clear goals is a great starting point for investors considering factor-based investing. And for those taking it up, strong discipline and a diligent focus on these goals are a recipe – but not a guarantee – for success.
1. The names may be familiar. Graham and Dodd wrote the book on security analysis, imaginatively titled Security Analysis. And Benjamin Graham's college classes on value investing inspired a young college student named Warren Buffett.
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Issued by Vanguard Asset Management, Ltd, which is authorised and regulated in the UK by the Financial Conduct Authority.