A growing number of institutional investors use factor insights in constructing portfolios, managing risk or allocating capital. However, few investors have adopted a holistic approach to factor investing.
Holistic factor investing calls for a robust integration of factor insights across the entire investment process, encompassing asset allocation, portfolio construction, risk management and performance attribution.
Asset allocation: Understanding factors and how they fit in the portfolio
At the asset allocation level, understanding the investment case and performance characteristics for each factor is critical. In equities, MSCI has identified six factors that historically have generated excess returns over long time periods: minimum volatility, value, size, quality, momentum and yield. Similar factors also can be identified in other asset classes.
Institutional investors may have numerous questions as to how factors fit into their portfolios. For example, what drives value? Why does the low volatility anomaly exist? How do factors correlate to each other? Depending on their investment beliefs, risk tolerance and constraints, institutional investors may select to which factors they seek exposure, and at what allocation levels.
The desired long-term exposure to factors would be reflected in the policy benchmark. Alternatively, some institutional investors have explored using a reference portfolio—a simple “shadow” portfolio used in evaluating active bets.
Portfolio construction: Increasing the number of building blocks used in constructing portfolios
Once the policy mix has been determined, institutional investors then turn to the task of implementing the allocation. Historically, investors could choose between passive investing, which aims to replicate market returns, and active investing, which seeks to beat the market. Now, a third option is available: harvesting factor return premia via transparent, rules-based strategies.
Risk management: understanding factor exposures
Exposure to systematic drivers, such as factors, typically accounts for a significant proportion of portfolio return, even for an actively managed portfolio that was built from the bottom up. Therefore, it is critical to understand each portfolio’s aggregate factor exposures. This understanding should span both investable factors (whose returns can be expressed as portfolios) and underlying macroeconomic factors (such as gross domestic product growth and inflation, which are not directly accessible via securities).
Performance attribution: Has the portfolio met its objectives?
Finally, each institutional investor should review the portfolio’s performance to see whether it has met its investment objectives and whether its implementation was efficient. Among the key questions: How did factor tilts contribute to the portfolio's return? Did the manager deliver true alpha above what could have been achieved via index-based factor strategies?
A framework for using factors throughout the investment process
We summarize these steps in the following framework:
As factor investing evolves, institutional investors are faced with a growing variety of approaches and investment solutions. A framework that incorporates advanced factor analytics and index-based factor strategies can help asset owners evaluate these policy decisions and approaches.
The author thanks Chin Ping Chia for his contributions to this post.