As a professional investment strategist, I think of the end of the year as Silly Season.
So many firms roll out their chief strategists and make predictions. Just for fun, in my next article, I’ll compare the 2017 predictions to the 2016 predictions. What happened with 2016 predictions? Were they successful? Some yes, some no. What might we learn from that?
As Donald Rumsfeld famously said, there are known unknowns, and then there are unknown unknowns. Some things about the markets and the economy are predictable, but others—often the most important things—are not. Innovation is unpredictable, for instance, and it is a huge game-changer for the markets. It would fall into the known unknown category. And then there are the unknown unknowns, the black swans that can devastate markets—or spawn explosive growth. Who knows?
As factor-based investors, we look to what’s predictable, based on decades of academic research. Many, many studies have shown that outperformance—alpha—can, to a great extent, be quantified, and characterized by certain characteristics of stocks, called factors. At my firm, Efficient Advisors, we use four of the most dominant factors to guide our portfolio construction approach. We start by trying to capture the global market at large, as inexpensively as possible, and then we adjust our weightings to reflect those factors that we believe will create outperformance. We overweight small cap and value stocks; we overweight stocks of highly profitable firms and stocks with positive momentum.
Steps to a Factor Portfolio
Out of the starting gate, the most inexpensive way to capture market performance is with a global, market-cap-weighted portfolio. This may be the most plain-vanilla way to invest today. Next, we have to decide: to what degree do we want to look different? This is where we – and the advisor – can add value.
There are two ways a factor investor can add value: the degree to which you hold more-risky and less-risky assets (i.e., asset allocation) and the degree of factor-tilting you embrace within broad asset classes. This means small and value in stocks, for example, and duration and credit-quality in fixed income. Each of these multi-faceted decisions have portfolio implications that need to be considered.
Asset allocation is the most obvious and familiar. Here, our approach centers on offering a range of portfolios to meet the needs of investors with varied risk/return objectives and time horizons.
What to Tilt?
Next come the factors—you could almost think of them as an overlay. We believe in presenting advisors with several ways to implement them, with varying degrees of alignment. We want to give advisors flexibility, because there are going to be times that factor exposure may not look like the best approach.
How much do advisors think they can look different from the market and still keep their clients committed? We don’t want their clients to be muttering about going to cash.
We offer advisors three basic options within our factor framework, which differ in the degree of factor tilt. Our Core portfolios are mildly tilted; our Factor portfolios are more moderately tilted; and our Factor Plus portfolios have the strongest factor orientation. We then help advisors align their value proposition and talking points to clients with whichever of these implementation options resonates most strongly with them.