The investment portfolio X factor

24 February 2020 | Portfolio construction


Australian investors are increasingly using managed funds and exchange traded funds (ETFs) as the core building blocks for their equity exposures.

Most portfolio construction strategies are primarily focusing on 'passive' index-tracking funds (which deliver a market index return minus costs) and actively managed funds (which seek to outperform the broader market) made up of companies hand-selected by portfolio specialists.

But there's another key weapon in the portfolio construction arsenal that's also gaining stronger interest from investors.

Neatly sitting between passive and actively managed funds is a suite of investment fund products that have been specifically designed to deliver market outperformance based around distinct investment factors.

What are investment factors?

In an investing context, factors are the underlying behavioural attributes that influence the market performance of every company to greater or lesser degrees.

Factor-based funds use a rules-based actively managed approach to invest in companies that exhibit the specific characteristics aligned to their underlying strategy.

In doing this they essentially filter out companies that don't meet their particular investment criteria. Depending on the factor strategies chosen, they can deliver investment returns that are superior to the broader market over the long term.

These types of funds can be used to calibrate a portfolio through exposures to one or more factors, or as a total portfolio strategy to manage investment risk.

Think, for example, if you were concerned about market volatility. Equity markets move up and down every day, and some companies, because of either the nature of their industry, the state of their operations or other external influences, often experience higher volatility than others.

Listed companies with low volatility historically have achieved better risk-adjusted returns than those with higher volatility.

A factor-based managed fund or ETF focused on minimising the impact of market volatility on a portfolio actively filters out the most volatile companies, with the objective of providing investors with greater stability over time.

Other types of factor strategies

Value: Relatively inexpensive stocks from undervalued companies historically have earned higher returns than expensive stocks. A value-focused factor fund uses defined metrics to actively target undervalued companies and thereby deliver above-market returns.

Momentum: Companies with strong recent performance historically have earned higher returns than those with weak recent performance. A momentum-focused factor fund actively targets the shares that have exhibited the strongest recent performance.

Quality: For investors who want to focus on companies with strong fundamentals, which may include higher operational earnings and balance-sheet quality.

The key benefits of factors

Factors are academically tested drivers of long-term investment growth, and factor-based funds use systematic, logical and repeatable quantitative processes to stay true to the factors they've been designed to track.

While human investment managers do oversee the process on an ongoing basis, active factor funds don't involve portfolio managers having to make subjective decisions on whether a company should or shouldn't be included in the fund.

In other words, companies will automatically be included in a factor fund as long as they meet the relevant investment parameters, such as around minimum volatility, value, momentum or quality.

Importantly, this consistent process removes the need for individuals to make personal judgement calls and eliminates key person risk, because factor funds are not reliant on the expertise of individual investment managers to select companies they believe will outperform the broader market.

Furthermore, while a seasoned active manager or even a team of people can readily manage a portfolio incorporating dozens of companies, a factor-based product can manage thousands of individual shares every day because it's computer driven. Factor funds are rebalanced on a constant basis.

The broader market return, combined with different style factors, will generally account for the bulk of a traditional total returns.

Investors generally have a range of factor exposures built into their portfolios anyway, whether through very deliberate decisions or because of an existing investment process.

By deliberately focusing on factor exposures as part of the portfolio construction process, investors have full transparency by knowing what they own and get a clearer view of the potential drivers of portfolio returns.

Talent, cost and patience

Factor-based investing represents a dynamic tool designed to help investors achieve specific investment goals.

As with any type of active investment strategy, the essential elements remain talent, cost and patience.

The investment talent behind the development and implementation of the factor product strategy will be key to its long-term performance. So will cost. The lower the management expense ratio, the more investors get to keep out of their total returns.

Direct targeting of factors through factor-based funds can offer the many benefits of traditional active mutual fund investing but at a lower cost and with less manager risk.

But patience should not be overlooked in factor strategies. Factor timing is extremely difficult, and strategies that attempt to do so are ill-advised.

Investors need to have patience over the long-term to stick with a factor-based investment strategy.

Source: Vanguard


Tony Kaye

Tony Kaye
Personal Finance Writer
Vanguard Australia