Factor-Based Strategies

Suppose you're a retired investor living off your portfolio's income in retirement. Since this is your only source of income, it must be invested in a way that meets your risk tolerance and needs. What type of portfolio would you prefer in this situation?

No way. That's going to incorporate too much risk for the retired investor.

Not quite. Some growth is good, but this retired investor is primarily focused on income.

Given that research indicates higher returns for small-cap stocks, how do you think this impacts a small-cap stock's risk premium versus a large-cap stock's?

No, it's not. Small-cap stocks usually earn higher returns, which doesn't indicate a lower risk premium.

For example, passive factor-based strategies can capture specific factors that tilt portfolios to be overweighted or underweighted in certain areas. But even these passive strategies can involve active management. What would be an active management task associated with implementing a passive factor-based strategy?

That's not it. Risk and return have a positively correlated relationship.

No. In general, the indexes used in passive strategies are pretty standard, so that's not really an active management decision.

That's not it. Index selection doesn't deal with the implementation of the passive strategy.

But after the passive strategy is implemented, research has found that passive factor-based strategies tend to concentrate risk exposures, which leaves investors exposed when their chosen risk factor isn't in favor. What type of performance should this investor then expect?

Unfortunately, no. The investor is overexposed to the unfavored risk factor, so that's not positive.

How would a security with very low volatility be weighted versus a security with high volatility?

No. Overweighting certain risk factors and underweighting others isn't going to achieve market performance.

No. If a higher volatility stock were weighted higher, that would increase risk, not decrease risk.

No. Volatility weighting focuses on minimizing risk, so there's unequal weighting.

Risk weighting is advantageous for investors in that it's easy to understand and provides a way to reduce absolute volatility and downside returns. But there's also a significant disadvantage in how the price return data is calculated. What might be an issue in using historical price data to calculate volatility?

Yes! Historical return data doesn't always capture the volatility of future returns, so it's not the best approach for analyzing risk. That's where diversification strategies come in. These include equally weighted and maximum-diversification strategies. These strategies attempt to maximize future diversification by determining portfolio weights using past price return volatilities. In addition to the factor strategies, many managers also consider the benchmarks they're competing against. Usually managers will use multiple benchmarks, including factor-based indexes and a broad market-cap weighted index. But this can lead to tracking errors where the standard deviation of returns from the benchmark don't match the standard deviation of returns from the portfolio.

No. Historical fees aren't the issue in using historical price data.

Not quite. The focus is on risk, not liquidity, so liquidity isn't the main concern.

One final consideration of factor-based strategies is the impact of fees. In general, factor-based strategies involve investment professionals who create and manage these strategies. What do you think the cost of factor-based strategies is in comparison to the cost of a broad market index?

No, actually. This management versus a low-cost broad market index doesn't make the fees lower.

That's right! Since there are more criteria for creating a factor-based strategy, the fees are higher in general. These fees can include both commissions and management fees, which decrease performance. But factor-based strategies usually have lower fees than outright active management and can provide pure exposure to specific market segments. Since factor-based strategies are rules based and don't require constant rebalancing, total fees are lower than active management, with the added benefit of some potential outperformance based upon specific factors outperforming.

That's not it. The broad market–based index is low cost and requires minimal management.

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Of course! As a retired investor, you'll want to focus your portfolio on earning income since that's your source of funds. It's the best choice and one that demonstrates the application of factor-based strategies. A factor-based strategy identifies a client's risk factors and isolates them. These factors can include size, value, quality, and momentum.

Exactly! If small-cap stocks are anticipated to have a higher return, then the risk premium should be higher as well. That's part of the natural relationship of the risk factors—higher returns require higher risk. And now the risk factors developed by Fama and French have evolved into full-fledged investment opportunities.

That's right! Implementing a passive factor-based strategy still involves choices regarding the timing and degree of factor exposure. It can be said that passive factor investing incorporates active management at the initiation of the strategy.

Exactly. If the passive factor-based strategy investor's chosen factor isn't in favor, then the investor's portfolio will underperform. So many times, investors will combine different factors like growth, value, size, yield, momentum, quality, and volatility. But no matter what factors are used, the goal is to improve the risk/return performance of the market-cap-weighted strategy. These strategies include return-oriented strategies, risk-oriented strategies, and diversification-oriented strategies. Return-oriented, factor-based strategies include dividend yield strategies, momentum strategies (momentum is a stock's excess price return relative to the market over a specified time period), and fundamentally weighted strategies. Risk-oriented strategies seek to reduce downside volatility and overall portfolio risk. This can include volatility weighting, where constituents are weighted inversely to their relative price volatility.

Indeed! Since volatility weighting uses inverse weighting to the price volatility, a security with lower price volatility will have a higher weight. This can be measured through trading-day standard deviations or weekly standard deviations. Volatility weighting can also be achieved through minimum variance investing, where a mean–variance optimizer minimizes portfolio volatility by analyzing historical price returns subject to certain constraints like geographical and concentration weightings and over/underweightings.

These factors impact the choice of a benchmark. Initially, this factor-based approach started from research that noted that small-cap stocks tend to outperform large-cap stocks. Fama and French elaborated on this by developing five risk factors that explain US equity market returns. The five risk factors are market risk premium, company size, book-to-market equity, operating profitability, and investment intensity.

Emerging-markets focused

High-growth stocks focused

Dividend and interest focused

It's lower

It's higher

It's the same

Which index to use

How many indexes to use

Timing and degree of exposure

Outperformance

Underperformance

Market performance

Lower weighting

Equal weighting

Higher weighting

Past return data doesn't always reflect future returns

Past return data incorporates higher fees than in the future

Past return data doesn't capture the higher liquidity of current data

Lower

The same

Higher

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