The term ‘factor’ refers to the various forces that have historically-driven risk and return within and across asset classes. By basing asset-allocation decisions more explicitly on these factors, investors may find new opportunities to construct portfolios with lower correlation properties or greater return potential than would otherwise be possible. By focusing on the presence and nature of underlying risk factors driving portfolio returns, instead of simply on achieving diversification across asset classes or market sectors, investors can potentially enhance their exposure to risk premia, which may yield superior risk-adjusted returns compared to traditional portfolios.
Diversificaton May Not Be Sufficient
Traditionally, investors allocate across asset classes including equities, fixed income, real estate, commodities or private equity in order to reap the benefits of portfolio diversification. However, while each asset class is under the influence of multiple risk factors, asset class diversification alone may not be sufficient. As the financial crisis had revealed, a few factors can blow overwhelmingly causing all assets to move in the same direction like boats in the winds and waves of a storm. Factor-based investing approaches seek to identify underlying risk conditions that may exist across asset classes and make investment decisions with the goal of achieving a more even-keeled portfolio throughout market cycles.
The Difference Between Equity and Fixed-Income Factor-Based Investing
While factor-based approaches have gained prominence in equity markets—where roughly $45 billion flowed into US factor investing, or ‘smart beta,’ exchange-traded funds last year— fixed-income investors may also benefit from strategies that allocate assets based on exposure to risk factors. However, there are inherent differences between equity and fixed-income markets; namely, a company may have many different bond issues outstanding in an over-the-counter market that is structurally much less liquid. Therefore, simply adopting the filtering methods commonly used in stock indices to overweight exposure to factors such as momentum, value, quality or size is not practical. Instead, fixed-income investors should focus on factors that can be captured through systematic strategies with liquid instruments using a transparent, rules-based trading process.
Sources of Market Risk Premium
The familiar sources of market risk premium for fixed income include term structure, inflation expectations, default or credit risk and liquidity. However, investors may also be compensated for obtaining exposure to (1) investors’ behavioral biases that produce price momentum; (2) relative-value opportunities as asset prices revert to fair value; (3) carry trades resulting from the mispricing of assets with additional yield or higher income streams and (4) volatility due to the premium available for insuring against certain market events.
Attributes Of Both Active and Passive Management
While exposure to risk factors can provide alternative sources of return beyond traditional beta, to be viable as investments, factors need to be intuitive, demonstrate evidence of delivering a persistent risk premium and be able to be harvested with liquid instruments. Alternative risk factors should also demonstrate low correlations against traditional asset classes in order to truly deliver diversification benefits.
Factor-based investing approaches sit somewhere beyond active and passive investment management and possess attributes of both. Risk-based portfolio construction techniques provide investors another tool to either complement the beta exposures of an existing portfolio, or to provide an alternative source of alpha beyond the security selection or sector rotation of traditional fixed-income strategies. Long-term institutional investors are uniquely positioned to take advantage of factor-based investing approaches given their long time horizon and ability to weather market cycles in the pursuit of higher risk-adjusted returns. Obtaining exposure to risk factors through investable, systematic, rules-based strategies can further enhance market capacity, liquidity and rebalancing agility for large asset owners. Learn more about our approach to factor-based fixed income investing here.
The comments provided herein are a general market overview and do not constitute investment advice, are not predictive of any future market performance, are not provided as a sales or advertising communication, and do not represent an offer to sell or a solicitation of an offer to buy any security. Similarly, this information is not intended to provide specific advice, recommendations or projected returns of any particular product of Standish Mellon Asset Management Company LLC (Standish). These views are current as of the date of this communication and are subject to rapid change as economic and market conditions dictate. Though these views may be informed by information from publicly available sources that we believe to be accurate, we can make no representation as to the accuracy of such sources nor the completeness of such information. Please contact Standish for current information about our views of the economy and the markets. Portfolio composition is subject to change, and past performance is no indication of future performance.
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