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FACTOR-BASED STRATEGIES

Factor applications

See examples of how equity factor-based investing can be applied in real world portfolio construction.

Overview

When constructing a portfolio, factor exposure can be achieved by using a variety investment options, including style index funds, low-cost active funds, or factor funds and ETFs.


Here are several examples of how equity factor-based investing can be applied in real-world portfolio construction.

Substitution for high-cost active

Comparison of two hypothetical funds: A high-cost active fund and a factor fund. The sources of the funds' equity return variation are represented by pie charts. The first chart shows a high-cost active fund with an expense ratio of 1.12%. Around two-thirds of the fund's performance variation can be attributed to market exposure. Most of the remaining third is attributed to style factors, while manager alpha accounts for an insignificant sliver of return variation. Hence, the active manager's stock-selection skill isn't influencing performance. The second chart shows a factor fund with an expense ratio of 0.09%. Around two-thirds of the fund's performance variation can be attributed to market exposure. The remainder is attributed to the same style factors as the active fund. Since the factor fund can replicate the performance of the active fund at a much lower cost, it would be a good candidate for substitution.

This hypothetical illustration is for representative purposes only and does not represent a specific investment.

Substituting for high-cost active

Comparison of two hypothetical funds: A high-cost active fund and a factor fund. The sources of the funds' equity return variation are represented by pie charts.

The first chart shows a high-cost active fund with an expense ratio of 1.12%. Around two-thirds of the fund's performance variation can be attributed to market exposure. Most of the remaining third is attributed to style factors, while manager alpha accounts for an insignificant sliver of return variation. Hence, the active manager's stock-selection skill isn't influencing performance.

The second chart shows a factor fund with an expense ratio of 0.09%. Around two-thirds of the fund's performance variation can be attributed to market exposure. The remainder is attributed to the same style factors as the active fund.

Since the factor fund can replicate the performance of the active fund at a much lower cost, it would be a good candidate for substitution.

Opportunity

Are you overpaying an active manager just to get factor exposure?

After analyzing your client's portfolio, you discover that a particular manager's returns are largely explained by common factor exposures. In fact, you find:

  • A constant factor exposure over time.
  • No additional return being added through security selection or market-timing.
  • An inability to overcome the high-cost hurdle.

 

Strategy

Keep the desired factor exposure, but at a lower cost, by replacing a high-cost active fund with a low-cost factor product.

 

Potential benefits

  • Cost savings.
  • More targeted exposure to a desired factor.
  • Greater transparency.

 

Caveats

Not all active funds are good candidates for substitution.

 

Works with these factors

factor application symbols

Design exposure tilts using our factor products.

Help enhance portfolio return

Comparison of two hypothetical portfolios: An index-based portfolio and a mostly index-based portfolio that uses factor products to make an equity factor tilt. The portfolios' factor exposures are represented by pie charts. The first chart shows an index-based portfolio designed to track the market. Since market exposure is the only source of return variation, there is no chance for the portfolio to outperform. The second chart shows the effects of adding an equity factor tilt to the hypothetical portfolio. Value and momentum now account for about 10% of the portfolio, creating an opportunity for the portfolio to outperform the market.

This hypothetical illustration is for representative purposes only.

Enhance Portfolio Return

Comparison of two hypothetical portfolios: An index-based portfolio and a mostly index-based portfolio that uses factor products to make an equity factor tilt. The portfolios' factor exposures are represented by pie charts.

The first chart shows an index-based portfolio designed to track the market. Since market exposure is the only source of return variation, there is no chance for the portfolio to outperform.

The second chart shows the effects of adding an equity factor tilt to the hypothetical portfolio. Value and momentum now account for about 10% of the portfolio, creating an opportunity for the portfolio to outperform the market.

Opportunity

You want to help clients outperform the equity market over a long time horizon.

You may typically use index funds to gain equity market exposure. While this approach keeps costs low and helps create more predictable results, clients may have voiced these desires/concerns:

  • Clients believe it is possible to outperform the broad market over time.
  • Clients looking to outperform are considering moving assets to a different advisor.
  • While traditional active management may outperform over time, the challenge is finding a good active manager at a reasonable cost.

 

Strategy
Help decrease the risk of losing clients by using an equity tilt toward a factor that you believe will help them achieve their outperformance goals in a cost-efficient manner.

 

Potential benefits

  • More control over performance drivers versus traditional active management.
  • No reliance on an active manager's stock-selection skills.
  • Lower costs and greater transparency than traditional active management.

 

Caveats

  • Any given factor may underperform the market for a significant period of time.
  • There is no guarantee the factor tilt will improve long-term results.

 

Works with these factors

factor application symbols

Design exposure tilts using our factor products.

Reduce portfolio volatility

Comparison of two hypothetical funds: A high-cost active fund and a factor fund. The source of the funds' equity return variation are represented by pie charts. The first chart shows a high-cost active fund with an expense ratio of 1.12%. Around two-thirds of the fund's performance variation can be attributed to market exposure. Most of the remaining third is attributed to style factors, while manager alpha accounts for an insignificant sliver of return variation. Hence, the active manager's stock-selection skill isn't influencing performance. The second chart shows a factor fund with an expense ratio of 0.09%. Around two-thirds of the fund's performance variation can be attributed to market exposure. The remainder is attributed to the same style factors as the active fund. Since the factor fund can replicate the performance of the active fund at a much lower cost, it would be a good candidate for substitution.

This hypothetical illustration is for representative purposes only.

Reduce Portfolio Volatility

Comparison of two hypothetical funds: A high-cost active fund and a factor fund. The source of the funds' equity return variation are represented by pie charts.

The first chart shows a high-cost active fund with an expense ratio of 1.12%. Around two-thirds of the fund's performance variation can be attributed to market exposure. Most of the remaining third is attributed to style factors, while manager alpha accounts for an insignificant sliver of return variation. Hence, the active manager's stock-selection skill isn't influencing performance.

The second chart shows a factor fund with an expense ratio of 0.09%. Around two-thirds of the fund's performance variation can be attributed to market exposure. The remainder is attributed to the same style factors as the active fund.

Since the factor fund can replicate the performance of the active fund at a much lower cost, it would be a good candidate for substitution.

Opportunity

You are looking for ways to reduce portfolio volatility but stay invested in stocks.

After conducting due diligence on a portfolio, you may determine that your client needs to shift some of his or her equity exposure into a more conservative approach that helps reduce overall portfolio risk. Rather than shifting assets away from equities into fixed income, you may allocate a portion into a minimum-volatility strategy.

Strategy


Use a low-volatility tilt to help reduce the absolute risk in a portfolio over the long term.

Potential benefits

  • Low-cost way to dampen volatility.
  • More control over risk exposure.
  • Potential for higher risk-adjusted returns.

Caveats

  • Long-term returns will likely trail the broad market.
  • Potential for higher tracking error.

 

Works with these factors

factor application symbols

Design exposure tilts using our factor products.

Calibrate factor exposure

Comparison of two hypothetical portfolios: One whose factor exposure levels are not calibrated to a client's tolerance levels, and one whose factor exposures are calibrated. The portfolios' factor exposures are represented by pie charts.

This hypothetical illustration is for representative purposes only.

Calibrate Factor Exposure

Comparison of two hypothetical portfolios: One whose factor exposure levels are not calibrated to a client's tolerance levels, and one whose factor exposures are calibrated. The portfolios' factor exposures are represented by pie charts.

Opportunity

Factor exposures don't fit a client's tolerance range or long-term plan.

You built a client's equity portfolio using broad-market indexes and active managers. Despite performing proper due diligence during construction, a recent analysis revealed one or more of the following:

  • Active decisions that resulted in unintended factor exposures.
    A particular factor exposure that now exceeds the client's tolerance range.
    That adjusting exposures can help align the client's portfolio with his or her goals.

 

Strategy


Sell a portion of the traditional active assets and put the proceeds toward products that will help balance the portfolio's factor exposures.

Potential benefits

  • Better align clients' factor exposures with their preferences.
  • Help control unwanted risk exposures that may occur as a byproduct of active decisions.

 

Caveats

  • Factor exposure is time-variant.
  • Recurring maintenance or rebalancing might be required.

 

Works with these factors

factor application symbols

Design exposure tilts using our factor products.

Learn more about factor-based strategies

Got questions about factor-based strategies? Contact us.

Disclosures and footnotes

All investing is subject to risk, including possible loss of principal.

Factor funds are subject to investment style risk, which is the chance that returns from the types of stocks in which the fund invests will trail returns from U.S. stock markets. Factor funds are subject to manager risk, which is the chance that poor security selection will cause the fund to underperform relevant benchmarks or other funds with a similar investment objective.