This is a sponsored article from Vanguard.
Factor-based investing has boomed in popularity in recent years as accelerating technology offers investors a systematic and disciplined approach to enhancing returns and controlling risk.
When it comes to portfolio construction, how can factors be used? Since each investor has a unique combination of objectives, constraints, due-diligence capabilities, and belief sets, it is inadvisable to suggest a universal equity factor tilt approach.
Vanguard – the market leader in low-cost investing – has identified four applications of equity factor-based investing in real-world portfolio construction that help investors achieve their objectives.
1. Enhance potential returns
Investors seeking to outperform the equity market over the long term can consider an equity tilt towards individual factors or a multifactor strategy to achieve outperformance goals in a cost-efficient manner. Historical evidence has shown that equity factor tilts have outperformed over the long term (see Chart 1).
While low-cost indexing helps provide more predictable results in gaining equity market exposure, investors may be drawn to the allure of outperformance with an active manager. The challenge is to find talented active managers at a reasonable cost.
Using an equity factor tilt can help overcome this challenge by providing more control over performance drivers, eliminating reliance on managers’ stock-selection skills, as well as offering lower costs and greater transparency compared with traditional active management.
Chart 1: Numerous equity factor tilts have outperformed historically
Past performance is not a reliable indicator of future results. Notes: All results are as of 30 September 2016. Excess returns are calculated relative to the MSCI World Total Return Index (USD). MSCI World Momentum Index (USD) history begins 31 May 1973; MSCI World Value Index (USD) is from 31 December 1974, to 30 November 1997, and MSCI World Enhanced Value Index thereafter; MSCI World Quality Index (USD) begins 30 November 1975; and FTSE Developed Illiquidity Factor Index (USD) begins 30 September 2001. This figure includes back-tested index performance. Past performance is not indicative of future performance. For illustrative purpose only.
Sources: Vanguard calculations, using data from Thomson Reuters Datastream, MSCI, Bloomberg, and FTSE.
2. Reduce risk
If an investor seeks to reduce volatility in their portfolio while staying invested in stocks, some of the equity exposure can be shifted to a minimum volatility factor strategy to reduce overall risk.
This low-volatility tilt helps reduce overall risk in the long term, and the low-cost approach simultaneously provides more control over risk exposure as well as potentially higher risk-adjusted returns.
3. Substitute for high-cost active
Traditional active management can be a high-cost approach to simply gaining factor exposure. A particular active manager’s returns could be largely explained by common factor exposures without adding any returns through security selection or market timing.
By replacing a high-cost active fund with a low-cost factor product, the investor could maintain the desired factor exposure while saving money and gaining greater transparency.
4. Calibrate exposure
In some cases, unintended factor exposures may not match the investor’s risk tolerance or long-term objectives. If a portfolio is built using multiple active managers, active decisions may have led to unintended factor exposures or a particular factor may exceed the investor’s tolerance range over time.
The solution could be selling a portion of the traditional active assets and using the proceeds to balance factor exposure, creating a portfolio that is better aligned with the investor’s objectives and which helps control unwanted risk exposures arising from active decisions.
Keys to successful factor investing
Successful equity factor-based investing requires a thorough approach to due diligence and portfolio construction. Investors should determine which factors will help them meet their goals, what portfolio configuration best suits their objectives and philosophy, and how implementation costs may affect performance.
Vanguard’s actively managed, rules-based approach to factors enables investors to harness well-known factor exposures in a transparent, low-cost way.
For more on factor investing, visit www.vanguard.com.hk/factor investing.
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This is a sponsored article from Vanguard.