Managed funds: Max Riaz
Instead of investing by asset type or region, there’s a promising new way to diversify a portfolio
Most investors have traditionally thought about diversification of risk and returns in their portfolios by asset type – bonds, equities, alternatives or exposures by a range of sectors and geographies. But in recent years there has been a relative new theory on the block for achieving portfolio diversification. It calls for constructing diversified portfolios by use of “factors”.
A factor is simply a characteristic or trait that is shared or exhibited across a group of investible securities and has shown consistency in delivering above-market returns. And the idea is that one can mix different factors together in a portfolio to get better diversification in an era when most asset types have become highly correlated and investors have nowhere to hide when there is a general market sell-off. Factor-based investing strategies have also been supported by academic research.
I will concede that if you start going through the range of factors available to build a portfolio, then you are sure to be spoilt for choice – probably too much choice. Academics and investment managers have developed more than 600 factors over the past decade, leading some commentators to refer to these available choices as a “factor zoo”. But the efforts of Andrew L. Berkin and Larry E. Swedroe, through their book Your Complete Guide to Factor-based Investing: The Way Smart Money Invests Today, is worth a mention. They made a painstaking effort to simplify the process by filtering down to a handful of effective factors necessary for diversification. Their criteria were that the final set of factors must be “persistent” across long periods of time and economic conditions; they must be “pervasive” across regions, asset classes and sectors; they must be “robust” in the basis of their definition – for example, based on a quantifying measure such as price-to-book ratio, cash flow or the like. The factor must be “investible” in practice. And, finally, it must be logical in its explanation. On these sets of criteria, they were able to distil down to eight factors that matter in the end: market beta, the size factor, the value factor, the momentum factor, the profitability and quality factors, the term factor, the carry factor and the research coverage factor. It is exposure to these factors that determine the vast majority of a portfolio’s risk. Investors can mix and match assets held in their portfolio according to the abovementioned factor category they belong to. And a diversified portfolio can then be developed by carefully assembling the factors and their known correlations to each other and adjusting the portfolio’s tilts to certain factors over others to achieve a desired risk-adjusted return. I will throw in a word of caution here that all factors, including the ones mentioned, have experienced long periods of underperformance.