Factor Investing: A Post-Modern Portfolio Theory

Since Harry Markowitz published his Journal of Finance paper creating Modern Portfolio Theory in 1952, asset allocation, risk management and diversification have become the governing principles for portfolio construction.

Ask most financial advisors how they create a portfolio, and the first thing they’ll reference is “MPT.” They seek out assets that are not correlated, so gains in one will offset losses in another. They work with clients to trade risks for rewards, and seek out that ideal balance on an efficient frontier. Even now, after decades of tremendous market growth and shocks, Markowitz’s idea still forms the basis of modern portfolios.

Beyond strategic asset allocation, though, many if not most asset managers embrace various strategies beyond MPT in an attempt to enhance their portfolio performance in some way, typically seeking to increase returns, reduce downside risk or some combination of the two. These investment approaches — which include actively managed stock selection, dynamic or tactical asset allocation, and the use of alternative investments, among others — are a core tool for the majority of advisors and investment managers. Alas, any rigorous academic evidence that these strategies are actually effective is elusive.

In fact, the majority of academic research suggests that approaches like the ones mentioned previously — despite their noble objectives — have the exact opposite effect on portfolio outcomes. They tend to elevate portfolio volatility, increase costs, reduce tax efficiency and cause portfolios to underperform a strategic, low-cost, passively oriented approach.

Recognizing the power of this academic evidence, some asset managers, my firm included, have evolved their portfolio construction approach. We have created “post-modern portfolios,” which tweak the idea of asset allocation and diversification by seeking out types of securities that have been shown, by decades of academic research, to offer positive return premiums over time. We are not talking about tech stocks here, nor biotech or other high-profile, go-go industries. Instead, we are looking at certain investment characteristics — or “factors” — that have been suggested by research to systematically offer positive return premiums to investors over long periods of time.

Factor Investing = Dissecting Alpha

In the 1960s, Nobel Laureate Eugene Fama’s research showed that a portfolio of selected stocks won’t typically beat the broad market index. Factor research looks further, dissecting alpha to understand the elements of successful stock picking. It turned out that outperforming stocks share certain traits, which were given the name factors (see “Factor Investing Explained,” right).

There are literally hundreds of potential factors that have been identified, but academic research has helped narrow the field by identifying those that seem to have the greatest probability of minimizing risk while maximizing returns.

Based on this research and our own experience with factor investing, we have focused on these four factors that we believe to be most influential:

• Size: The propensity for small-cap stocks to outperform large-cap stocks over time

• Relative Price: The tendency for value stocks to outperform growth stocks over time

• Quality: The propensity for companies with higher profitability ratios to outperform those with lower-profitability ratios over time

• Momentum: The propensity for stocks with positive momentum to outperform the market in the near term and those with negative momentum to underperform the market in the near term

Two additional factors are also very popular among asset managers, though we don’t use them as often as the first four:

• Low Volatility: The tendency for a security’s value to remain stable, changing in value at a steady pace over time

• Dividend Yield: The tendency for companies who pay steadily growing dividends (relative to their share price) to outperform the market over time. This is highly correlated with the “Relative Price” or “Value” factor.

Instead of focusing at the asset class or individual security level to create a diversified portfolio of stocks, bonds, cash and alternatives, factor investing takes a more holistic approach to portfolio construction. The goal is to build and hold a broadly diversified global portfolio that offers exposure to a designated set of risk and return factors in an efficient, low-cost way.

How to Implement Factor Investing

Factor investing is a strategic approach that looks at diversification through a new lens. The emphasis is not on the investment vehicle or manager, ETF or mutual fund, stock or bond. Instead, securities are chosen based on whether or not they display one or more specific attributes or factors.

Because the approach is more strategy-based than product-based, advisors can select the least expensive, most efficient product that delivers consistent exposure to the chosen attribute.

At our firm, we tend to use ETFs or mutual funds that exhibit consistent factor exposures, broad diversification, low turnover and low costs. Firms such as FlexShares, iShares, AQR, DFA, State Street and others are focused on delivering low-cost, factor-based exposure. Our role is to identify the right factors, do the proper due diligence and assemble a portfolio to achieve our desired factor tilts at the lowest cost possible.