On the uptrend: Equity factor-based investing

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This is a sponsored article from Vanguard.

Interest in factor investing has increased significantly over the past decade due to a number of factors including increased academic research, the push for improved performance in a low-return environment, and a renewed focus on managing risks from multiple angles.

New tools and technology have also entered the scene, offering a more systematic and disciplined approach to enhancing performance and controlling risk in the changing market environment. In addition, investors have increasingly focused on the importance of cost efficiency, transparency, and control that traditional active management may not be able to address.

In short, factor investing satisfies all of the requirements for those seeking targeted exposures at a lower cost.

Factors vs smart beta
This uptrend is demonstrated by the fact that equity factor-based or strategic beta product totals, which include both factors and smart beta products, surpassed US$1 trillion in assets in June this year, representing a 10-fold increase from less than US$100 billion a decade ago1.

The rise of equity factor investing

Source: Vanguard calculations, based on Morningstar, Inc., data as at 30 June 2018.

The terms “smart beta” and “factors” seem to be interchangeable in the market but smart beta is not necessarily equivalent to factors.

Factor investing is driven by strong empirical evidence and the persistence of certain security attributes to enable potential outperformance and/or lower risk relative to the broader market.

Smart beta, on the other hand, is generally a broader category that includes a variety of alternative (non-market cap weighted) indexes that strive to capture a market attribute, such as dividend yield, that may or may not represent a factor.

As an advocate of factor strategies, Vanguard — the market leader in low-cost investing — adopts a disciplined approach to factor investing, only taking products to market that have undergone exhaustive analysis and evaluation.

A deliberate, yet flexible approach
Representing a paradigm shift in how investors can capture key factor exposures such as value, liquidity, momentum, quality, and volatility, Vanguard’s approach hones in on consistent exposure to well-known factors that are designed to aid investors in meeting their objectives.

The three key tenets of this deliberate yet flexible investment approach are active management, broad diversification, and risk weighting based on factor scoring.

1. Vigilant and nimble: Redefining the active management approach
As investors seek a transparent, rules-based approach towards a variety of factors — value, momentum, liquidity, quality, and minimum volatility, amongst others — there is an increasingly pressing need for product and experience differentiation for factor investing to be able to meet investors’ goals.

To this end, while investors realise a rising need for the hands-on active management of factor products, the reality is that factor products currently available are still passively managed through index tracking.

Contrary to other products with a fixed rebalancing schedule, a factor approach featuring a flexible rebalancing schedule offers a structure for portfolio managers to maintain a targeted and consistent factor exposure over time.

By assessing factor exposures on a daily basis and rebalancing the portfolio in response to market movements, the detrimental impacts of factor drift or decay are mitigated. This active implementation helps deliver a consistently strong factor exposure for investors. It also provides greater flexibility in controlling the cost of implementation.

2. Leaving no stone unturned: Diversifying across all market-caps
With a view towards ensuring that key exposures do not fall through the cracks, best-in-class approaches focus on harnessing factor exposure across the entire spectrum of market capitalisation, rather than focusing on only large- or mid-cap ranges that may miss the value in small-cap equities, which typically have more significant factor exposures.

As such, Vanguard’s factor portfolios are designed to provide a high level of diversification in a cost-effective manner, corralling hundreds of stocks across the capitalisation spectrum including large, mid, and small securities in equal proportions, while reducing exposure to individual security risk and intensifying exposure to a targeted factor.

3. A new paradigm: Re-pegging securities weightings to factor exposure
While there are benefits to market-cap weighting, the best equity factor-based strategies should prioritise the degree of factor exposure above all else.

For its factor products to exhibit stronger factor exposure, rather than relying on market capitalisation and simply allocating higher weighting to large-cap companies, Vanguard ties securities weighting to factor scoring when calculating a stock’s weight in its respective portfolio. Using this approach, stocks with the highest factor scores will have the largest weighting for various buckets.

As factors continue to rise in popularity as a clearer lens through which to view risk and return, the key to potentially boosting excess returns and lessening risk lies in how the portfolio is constructed and managed. Vanguard’s differentiated approach for factor investing is designed to deliver strong and consistent exposure to target factors in a flexible manner.

Paired with a prudent and methodological approach towards selecting factors that have the highest propensity towards adding value for investors, factors work to both complement and reassess historical approaches to portfolio management, including sector, style, and regional allocations.

For more on factor investing, visit Vanguard’s Factor Hub.

1 Source: Vanguard calculations, using data from Morningstar, Inc., as at 30 June 2018. Based on ‘Strategic beta’ product category as defined by Morningstar, which includes both factors and smart beta products.

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This is a sponsored article from Vanguard.

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