Could factor based investing enhance your stock portfolio in 2020?

By Andrew Dougan, Director, Research and Analytics, FTSE Russell

The latest to go towards a more mainstream investing audience is factor-based investing. Often referred to as ‘Smart Beta’, factor investing is an approach that has gained traction rapidly over the last decade and is now used to manage over $1trillion of investor assets.

These strategies’ potential for improved risk-adjusted returns has led to successful adoption by pension funds, and a growing demand from retail clients.

The approach works by scanning stocks for certain attributes called risk factors and seeks to increase an investor's exposure to those that they believe will deliver the best risk-adjusted returns. The approach contrasts sharply to traditional stock picking, where investors analyse a single company, reviewing its financial accounts and speaking to management.

Five of the most common factors, momentum, volatility, size, quality and value, are frequently used by investment managers to construct stock portfolios. A listed company’s factor profile can of course change over time and many of these risk factors perform differently depending on the economic conditions.

The approach is growing in popularity. FTSE Russell’s annual Smart Beta survey, which looked at whether investors are integrating factors into portfolios, revealed adoption by 58 per cent of asset owners and other institutional investors globally in 2019, up 10 per cent since 2018. And within this growing field, multi-factor-based investment approaches are also gaining traction.

So what about market access to these investment strategies? One way individual investors can gain exposure to risk factors is via Exchange traded Funds (ETFs) where a fund passively tracks its underlying index and is traded on exchange, much like a stock.

If we look at the FTSE 100, the constituents in the index are weighted according to their market capitalisation. However, a single or multi-factor ETF based on this index would tilt the weighting of companies based on one or more desired factors.

For instance, an investment manager may think stocks with the quality factor, which looks at a combination of profitability, efficiencies and earnings are a better bet than value stocks, which are determined from other criteria such as the ratio of a company’s stock price to its earnings.

However, the issue of “off target exposures” remains a common cause for concern for investors that experience a gap between factor strategy intentions and actual outcomes. Given that factors are associated with positive long-term risk-adjusted returns, a systematic and unintended negative exposure to a factor could have a detrimental effect on portfolio performance.

Different methods of index construction yield different long-term results and investors must understand how this can impact investment performance.

FTSE Russell has recently introduced the FTSE Target Exposure Indexes to give investors the ability to pursue a variety of explicit factor exposures while retaining market, country and industry neutrality.

Not only are intended factor exposures realised but also unintended exposures neutralised.

This can be used for a variety of applications covering pure play single factor indexes, multi-factor indexing and to incorporate specific levels of climate objectives, such as carbon emissions from the stocks in an index.

As factor-based investing goes mainstream, investors need access to the right tools that will offer consistent exposure to desired outcomes.