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Positioning a portfolio using factors

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.



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