The Future of Factors

What is factor investing?

 

 

Photo: Kanenori: Source: Pixabay

Investment factors are a way to understand why stocks or bonds perform the way they do. Investments are driven by risks of various kinds. Bond returns are driven by duration, credit, prepayments, the yield curve, and – for global portfolios – currency risk. Stock returns are affected by their size, industry, quality, and country. Real estate is impacted by location and property type. And everything impacted by the economy, inflation, liquidity, the capital structure, management, and valuation.

One analogy is photography. A landscape photo is made up of all kinds of elements: color, balance, form. But it also can be a scene of activity and contemplation, as well as a seasonal image – fall, winter, spring. There are as many ways to look at art as there are to analyze an investment.

Factors allow us to slice and dice a portfolio differently. We can examine factor correlations just like asset class correlations. By diversifying our exposure to economic risk, or deflation risk, or liquidity, we can our portfolio’s risk while maintaining its returns. At least, that’s the way it’s supposed to work.

Source: CFA Institute, Yale University

True factor-based portfolios look very different from traditional buy-and-hold stock and bond portfolios. Exposure to credit risk comes from buying corporate bonds and shorting treasuries; exposure to valuation is created by owning a value stock index and shorting a growth stock index. There are a host of strategies that go into a true factor-based portfolio. They don’t look at all like traditional asset classes, just as a combination of random colors won’t look at all like a picture of mountains in the rain.

Source: CFA Institute, Yale University

This approach seems more like a collection of hedge-fund strategies than a classic investment portfolio for typical investors. While factors are real, and can help us understand our exposures, they can also become buzz-words, designed by marketers to create a new trend for people to hop onto. If folks aren’t careful, they wind up paying big fees for normal market exposure.

Factors can be a useful analytical tool, but they can also be misused to make people feel inadequate and that they don’t really know what’s going on. Remember: investment growth comes from economic growth. There’s no magic or mystery there. Factors just help us understand what risks we’re taking.

Douglas R. Tengdin, CFA

By | 2017-07-18T11:03:45+00:00 June 30th, 2017|Global Market Update|0 Comments

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