February 26, 2012

Why It’s Worth Factoring in Factors

Adding factor strategies to investment portfolios may provide investors with greater diversification, better wealth preservation and other benefits, argues Bill DeRoche of QuantShares

Proponents of factor investing – which differs from traditional asset allocation by focusing on specific return-driven strategies -- say it’s an efficient way to build portfolios and create more favorable risk/return profiles.

While an intriguing concept, some advisors may lack the analytic tools required to implement the theory. Also, their clients may lack access to the funds using factor investing.

That combination created an opening for factor-investment funds for retail investors, and several fund managers, including ETF-management firm QuantShares, now offer these products.

Bill DeRoche (left), CFA, QuantShare’s chairman and CEO, recently responded to questions about factor investing in an interview with AdvisorOne, such as the risk factors that can drive returns, like growth vs. value, as well as more esoteric measures such as volatility, momentum, dividend yield and the health of a company's balance sheet.

What is factor investing?

DeRoche: A factor represents a theme for grouping equities that helps explain return differences among securities. Factors are distinct from industries.

Factor investing involves using the selected theme as a mechanism for ranking each security within the investable universe. A set of rules then translates the ranks into long and short portfolio positions.

Consider a value example. Historically value stocks have outperformed stocks that are considered more expensive. Investors can capture this return difference through products that are long “cheap” stocks and short “expensive” ones. Value could be defined as a combination of ratios such as book to price and earnings to price.

Securities within the investable universe would be ranked from least expensive to most expensive by the defined factor. From the ranks, two portfolios are created, a long portfolio consisting of the top ranked securities and short portfolio consisting of the bottom ranked securities. The return difference or spread between the long and short portfolios will capture the “value premium”.

How long has factor investing been used in investment management?

Factor investing has been around for many years, though it has evolved substantially from its earliest days when Professors Graham and Dodd were teaching the benefits of value investing at the Columbia Business School in the 1930’s.

The addition of market neutral techniques to isolate a particular attribute was a big step in the evolution of factor investing. In the early 1990’s, the research of Professors Fama and French provided the basis for the value and small size factor strategies. Recently, the trend in factor investing has been towards passive investment products and more liquid offerings.

What are the analytics behind it?

Many of the more common investment factors depend on fundamental metrics derived from company financial statements. Market cap, valuation ratios, such as book to price or earnings to price, and returns provide the analytics necessary to build size, value and momentum factor portfolios.

These analytics are readily available from a number of third party vendors and are often used as the basis for investment decisions by portfolio managers.

As an investment strategy, how has it performed relative to the appropriate benchmarks?

As market neutral investments, it makes sense to evaluate these strategies in an absolute return framework. In particular, investors should consider the returns expected for the risks incurred. On this basis, two of the strategies that have performed well are value and small size.

These factors have delivered strong risk adjusted returns and could be considered for a strategic or long-term portfolio allocation. Other factors, though they explain a significant amount of volatility, tend to identify shorter-term movements in the markets. Allocations to factors in this category, such as momentum and beta, could be used for risk reduction or as a tactical short-term view.

Why should advisors consider factor investment-funds for their clients' portfolios?

More than ever, investors understand the importance of asset allocation, diversification and risk management. Adding factor strategies to an overall investment portfolio provides investors more opportunities to diversify, preserve wealth and minimize drawdowns while maintaining the potential for upside.

Factor-based portfolios offer a number of benefits to investors, including:

• Attractive returns relative to the risks incurred,

• Low correlations to the broad market offering significant diversification benefits,

• Hedge fund like returns at a lower cost, greater transparency and increased liquidity.

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