As the debate between active and passive management rages on, there has been more interest in a hybrid approach to building a portfolio using a factor-based approach.
This investment approach allows advisers to focus on market data evidence and academic research that have rewarded investors with enhanced returns over a market-weighted index, such as the S&P 500, while still maintaining broad market exposure and eliminating some of the inefficiencies seen in conventional active management, such as market timing.
“Factors can be thought of as an asset class DNA -- the distilled ‘motivators’ behind returns and equity,” says Michael Falk, a partner at Focus Consulting in Chicago, who advises asset managers.
Advisers Dave Alison and John Blood both use a multi-factor approach in portfolio building.
Typically, this approach uses “tilts” or increased exposure relative to an index toward various risk factors. Examples include the propensity of long-term outperformance of small-capitalization companies over large-cap companies over time, value companies over growth companies over time and profitable companies over less profitable companies over time.
“The most important component of multi-factor investing is ensuring the client has a proper time horizon to take advantage of these factors,” says Alison, a CFP and a founding partner and investment adviser at Prosperity Capital Advisors in Westlake, Ohio.
Most of his clientele are pre-retirees and retirees.
Alison recommends a three-bucket approach to segment clients’ money between a so-called now bucket, a soon bucket and a later bucket, which is focused on long-term growth, based on multiple factors of expected returns. Most of his clientele consists of pre-retirees and retirees.
“The bottom line is that the market is unpredictable in the short term, but if you can help segment the client’s money based on time horizon, they can dedicate their later bucket money to a strategic multi-factor asset allocation philosophy with confidence,” Alison says.
Similarly, Blood, a CFP and chief executive of Efficient Advisors in Philadelphia, recommends that advisers adopt a broad, passive factor approach, which he maintains can potentially deliver higher returns.
“Our approach allows us to focus on risk and behavioral factors that historically have rewarded investors with enhanced return over a market index while still maintaining broad market exposure,” he says. “By not taking large ‘bets’ on individual securities, sectors or countries, our objective is to reduce the risk of significant underperformance relative to traditional benchmarks.”
Although there are benefits to building a portfolio using factors, such as risk and return, correlated with other factors, the process isn’t without flaws.
“Just because any factor has shown to add value historically doesn’t mean it will in all market cycles. Factor tilts can cause market trailing returns in the short run,” Falk says.
“All investment strategies should be based around the client’s financial plan and the purpose of the client’s money,” Alison says.
This is part of a 30-30 series on ways to build a better portfolio.