By: Marlies van Boven, managing director, research & analytics
Factor investing has grown increasingly widespread, as many institutional investors are now recognizing the importance of incorporating factors into asset allocation decisions. In particular, there’s been growing interest in multi-factor solutions, which target combinations of rewarded investment risk factors that aim to improve portfolio diversification, enhance performance and/or reduce risk. To this end, we’ve identified three factor combinations that can be used to position portfolios to target specific objectives.
An investor looking to enhance risk-adjusted returns may seek a certain risk profile, and factor investing can build relevant, outcome-oriented solutions. For example, the aim may be to have a strategy that offers a higher relative risk with higher returns (Dynamic), or moderate risk and return (Diversified) or relatively low risk with moderate returns (Defensive). An overview of these options is summarized below:
Targeted multi-factor solution #1: Defensive
An investor seeking to improve risk-adjusted returns with downside protection would likely favor the Defensive solution, which combines Quality, Low Volatility and Yield factors. As its up- and down-capture ratios illustrated in the table below, the Defensive factor combination has historically offered capital protection during market downturns, but has also appreciated less than the other two multi-factor combinations during market upturns. The Defensive solution has also offered the lowest absolute risk, and the least amount of maximum drawdown—or the maximum loss from peak to trough, before a new peak is attained.
Targeted multi-factor solution #2: Diversified
The Diversified would be preferred by investors seeking modest outperformance over a broad market benchmark at market levels of absolute risk by combining Low Volatility, Quality, Yield, Value, Size and Momentum factors. As shown above, because of its diversified properties, it has on average outperformed the other two combinations in both up and down markets. The beta of the Diversified strategy is 0.96, versus 0.85 for the Defensive solution; in other words, it’s more sensitive to market direction. The maximum drawdown for a Diversified solution is higher relative to the Defensive combination, but slightly lower than that of the benchmark index.
Targeted multi-factor solution #3: Dynamic
The Dynamic combination is viewed as the most aggressive of the three solutions, with higher risk and a higher return objective. Its higher levels of volatility result in larger drawdowns, making a situation where an investor has a long-term investment horizon and strong governance important for realizing the potential of this more risky factor combination. This solution combines Value, Size and Momentum factors.
As shown below, FTSE Russell offers a number of index products designed to capture exposure to various combinations of factors. The FTSE Russell factor index framework permits an extensive degree of customization, spanning factor combinations, tracking error, capacity and turnover considerations.
It’s important to note that each investor’s unique return objectives, risk tolerances, investment horizons and governance will lead to different preferences regarding factors. Levels of exposure and sensitivity to investment capacity, concentration and turnover can also vary. A pension fund, for example, may wish to use factors to improve risk-adjusted performance relative to its current passive allocation. Other institutional investors may be more focused on downside protection during periods of heightened market volatility, while others may want to use a factor allocation to replicate the return potential of a style manager.
Professional investors can see our report, Implementation considerations for factor investing, for more detail on factor investing.
© 2018 London Stock Exchange Group plc and its applicable group undertakings (the “LSE Group”). The LSE Group includes (1) FTSE International Limited (“FTSE”), (2) Frank Russell Company (“Russell”), (3) FTSE Global Debt Capital Markets Inc. and FTSE Global Debt Capital Markets Limited (together, “FTSE GDCM”), (4) MTSNext Limited (“MTSNext”), (5) Mergent, Inc. (“Mergent”), (6) FTSE Fixed Income LLC (“FTSE FI”) and (7) The Yield Book Inc (“YB”). All rights reserved.
FTSE Russell® is a trading name of FTSE, Russell, FTSE GDCM, MTS Next Limited, Mergent, FTSE FI and YB. “FTSE®”, “Russell®”, “FTSE Russell®”, “MTS®”, “FTSE4Good®”, “ICB®”, “Mergent®”, “WorldBIG®”, “USBIG®”, “EuroBIG®”, “AusBIG®”, “The Yield Book®”, and all other trademarks and service marks used herein (whether registered or unregistered) are trademarks and/or service marks owned or licensed by the applicable member of the LSE Group or their respective licensors and are owned, or used under licence, by FTSE, Russell, MTSNext, FTSE GDCM, Mergent, FTSE FI or YB. “TMX®” is a registered trademark of TSX Inc. FTSE International Limited is authorised and regulated by the Financial Conduct Authority as a benchmark administrator.
All information is provided for information purposes only. All information and data contained in this publication is obtained by the LSE Group, from sources believed by it to be accurate and reliable. Because of the possibility of human and mechanical error as well as other factors, however, such information and data is provided "as is" without warranty of any kind. No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the accuracy, timeliness, completeness, merchantability of any information or of results to be obtained from the use of the FTSE Russell Indexes or the fitness or suitability of the FTSE Russell Indexes for any particular purpose to which they might be put. Any representation of historical data accessible through FTSE Russell Indexes is provided for information purposes only and is not a reliable indicator of future performance.
No responsibility or liability can be accepted by any member of the LSE Group nor their respective directors, officers, employees, partners or licensors for (a) any loss or damage in whole or in part caused by, resulting from, or relating to any error (negligent or otherwise) or other circumstance involved in procuring, collecting, compiling, interpreting, analysing, editing, transcribing, transmitting, communicating or delivering any such information or data or from use of this document or links to this document or (b) any direct, indirect, special, consequential or incidental damages whatsoever, even if any member of the LSE Group is advised in advance of the possibility of such damages, resulting from the use of, or inability to use, such information.
No member of the LSE Group nor their respective directors, officers, employees, partners or licensors provide investment advice and nothing contained in this document or accessible through FTSE Russell Indexes, including statistical data and industry reports, should be taken as constituting financial or investment advice or a financial promotion.
Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Index returns shown may not represent the results of the actual trading of investable assets. Certain returns shown may reflect back-tested performance. All performance presented prior to the index inception date is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. However, back- tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index.
This publication may contain forward-looking assessments. These are based upon a number of assumptions concerning future conditions that ultimately may prove to be inaccurate. Such forward-looking assessments are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially. No member of the LSE Group nor their licensors assume any duty to and do not undertake to update forward-looking assessments.
No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the applicable member of the LSE Group. Use and distribution of the LSE Group data requires a licence from FTSE, Russell, FTSE GDCM, MTSNext, Mergent, FTSE FI, YB and/or their respective licensors.