Understanding Factor-based investingAug 12, 2019

Understandings Factors header image

Over A Century of Evolution

When you look at the history of index investing, it is incredible how long it has been around and how much it has evolved over the past century. Indexing started in 1896 when Charles Dow, an editor at the Wall Street Journal and co-founder of the Dow Jones and Company, helped create the price weighted index. In the 1970s we saw the first glimpse of index investing with market cap weighted strategies, which allowed investors to gain broad based exposures to large markets around the world. Then in 2005, we saw the launch of the first smart beta strategy that used a single factor exposure and most recently we’ve seen a slew of multi-factor strategies being introduced into the marketplace.

Factor based investing has received a lot of buzz over the past couple of years, but I still hear a lot of confusion when I speak to advisors about how to use them, which is understandable, with so many options and strategies to choose from today. I am often asked three questions: which factor or factors should I choose; have factor-based approaches provided better results over the long term; and how easily can they be implemented into my existing portfolios?

Understanding Factors

Factors are not a new phenomenon. They have been showcased in a number of academic research papers and implemented through active strategies during the past few decades. What we are seeing today, with the advent of smart beta ETFs, is the creation of a true rules-based strategies that focus on either a single-factor or grouping several single-factors together. By removing the day-to-day discretion of an active manager, the cost has come down significantly, and the AUM growth of factor strategies, which is typically expressed in an ETF, has being quite amazing to see.

To understand factors, I think it is helpful to imagine them as a DNA marker that explains the primary characteristics of a stock’s behaviour over time. There have been six factors that have been most discussed by academics because historically they have rewarded investors with better outcomes over the long term:

  • Quality - companies with good profitability, earnings growth, low debt/equity.
  • Value - companies that are undervalued with lower valuation.
  • Momentum - companies that a have stronger recent price appreciation.
  • Low Volatility - companies with lower volatility or risk then the market.
  • Dividend - companies that are paying higher dividends per share on average then the market.
  • Size - companies with smaller market capitalization versus the overall market.

Delivering a desired outcome

So how do these different factors work together in your clients’ portfolios? The most basic strategy is a factor rotation strategy that focuses on a single factor. In this strategy you either overweight or underweight the factor based on the current economic cycle, but it’s worth noting that this can take a lot of work, result in higher trading costs and a potentially higher margin of error. Most importantly, when you’re attempting to pick and choose the right factors at the right time you will increase your market timing risk.

A multi-factor strategy gives investors access to investment vehicles that may smooth out the performance ride while delivering a desired outcome compared to a single factor rotation strategy. Of course, choosing the right multi-factor strategy is a key consideration too.

Our Multi-Factor Approach

At Franklin Templeton, our Smart beta ETFs are based on a multi-factor approach where we create a proprietary index that is custom weighted. For example, with FLEM our Franklin LibertyQT Emerging Market ETF we put our conviction behind the Quality factor at 50%, Value factor at 30%, Momentum factor at 10% and then the Low Volatility factor at 10%, as seen below.

Understanding Factors chart

I believe our multi-factor approach this tends to provide a truer bias to the factors that investors are looking to get exposure to. It eliminates the risk of duplication, where you may have similar stock positions being duplicated in each of the factor exposures that are being combined. Equally important is considering your weighting scheme. You can choose either equal weighted or custom weighted with conviction. With this approach it is important to look under the hood of each investment to see which methodology jives best with your investment philosophy.

Building A Better Portfolio

What are the benefits and how would a multi-factor strategy fit into an existing portfolio? Let build out a quick case study. I recently had a conservative client who was contemplating adding a small percentage to emerging market to her portfolio. Based on her current risk budget, she was hoping to maintain a similar drawdown as her portfolio that had no emerging markets exposure. We looked at adding an emerging markets allocation of 5% in both a multi-factor EM strategy and a passive mandate. Adding FLEM, a higher conviction multi-factor strategy helped smooth out the ride by capturing a lower overall max drawdown and worst month scenario in comparison to having a passive emerging market exposure in the portfolio. Even comparing to the original portfolio, the smart beta emerging market exposure provided a better ride.

Understanding Factors chart

This is just one example, but there are plenty of ways you can implement a multi-factor approach to your portfolio. Please feel free to contact me if you would like to learn more about the benefits of our unique multi-factor strategy used in our lineup of Smart Beta ETFs.