Let’s look at how factor allocations fit in the traditional institutional portfolio setting. Factor investing utilizing indexes can be viewed as active decisions implemented through passive replication. As such, factor allocations should be tailored to each institution.
The two main drivers of factor investing are the institution’s objectives and constraints.
Next, the institution must decide how to structure and implement the factor allocation.
The main criteria for deciding which combination of indexes to benchmark to will depend on the institution’s assessment of the tradeoff between replicability and factor exposure.
Indexes with greater replicability generally have lower factor exposure and vice versa. In this implementation phase there can also be significant turnover reduction benefits to combining multiple factors into a multi-factor index.
For example, “natural crossing” effects may reduce turnover, provided that the allocation is structured around a single passive mandate with synchronized rebalancing dates.
Traditionally, institutional investors structured their allocations around two main sources of return: passive (beta) or active (alpha.)
Now, multi-factor allocations replicating an index offer a new approach for institutional investors to seek factor returns, which have four key potential benefits, which we expanded upon here. They are flexibility, transparency, cost efficiency and diversification.
Institutions have full control over the selection and the weights of individual factor indexes within a multi-factor index and can adjust the strategic factor allocation dynamically through time. The most appropriate combination of individual factor indexes can be customized to account for institutional constraints.
We believe that the multi-factor approach provides flexibility: it can be created and managed easily within the passive mandate and without having to change the structure or the terms of the mandate. Because the multi-factor allocation relies on standardized indexes, it allows for the flexibility of employing existing passive instruments such as ETFs for tactical overlays. And this is what we view as a “building block” approach.
To read the full paper, please click here.