Why use factors?
16 November 2016 | Portfolio construction
James Norton: We're hearing a lot about factors these days, but what are they and why would we invest in them? My name is James Norton, Senior Business Development Manager at Vanguard, and I am here with Brian Wimmer, Senior Investment Strategist in our London office.
Brian, what is factor investing?
Brian Wimmer: Well, James, we like to think about factors as the DNA that explain the underlying risk and return characteristics within a portfolio. So if we take a simple example like a market-cap-weighted index, that is primarily driven by the market factor. But there are other factors in the equity markets, factors like quality, momentum, value that investors could potentially utilise in their portfolio.
James Norton: And why do people invest in them?
Brian Wimmer: Well, there are a few reasons. One of the reasons that we talk to investors about frequently is the potential to reduce overall volatility in their equity portfolio, using a strategy like a low volatility or a minimum volatility product.
James Norton: But it is not just about volatility and risk, I am hearing investors are using these to enhance returns as well.
Brian Wimmer: Absolutely. It is something that many investors are searching for, and, indeed, if we look at the historical evidence we have seen over long time periods, a number of factors have provided outperformance. But it is also important to note that there are periods of underperformance along the way.
James Norton: So how should people decide whether or not to invest in factors, and if they take that step, which factors to invest in?
Brian Wimmer: Well, if you think broadly about any form of investing, whether referring to factor investing, traditional active management or indexing, it comes back to understanding the specific investment objectives and targeting a certain level of risk and return. Now, if an investor has a specific view on the markets, such as an investor that prefers a value-oriented portfolio, one that targets undervalued securities in an attempt to try and outperform the market, a factor strategy could be utilised to express those views in their portfolio.
James Norton: So if you're using a traditional active manager to gain a specific exposure, you could use a factor ETF to gain that at a lower cost.
Brian Wimmer: It is certainly possible, and at Vanguard, we offer both traditional active management and factor investing, so we do see merits in both forms. But we also know at Vanguard the importance of low costs. So if you can take an expensive traditional active manager that is providing factor exposure and replicate some or all of that exposure with a lower-cost factor product, we think that is ultimately going to improve the odds of success for investors.
James Norton: Thanks, Brian.
Replacing a high-cost active strategy, potentially lowering a portfolio's overall risk, or improving returns are just some of the uses for factors.
Thanks for watching.
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