Tips For Better Factor Investing

June 03, 2019 How do you effectively rotate and mix factors? Northern Trust did a study recently that found a lot of institutional investors struggle to make factors work for them, and one of the big problems is in mixing them. You can dilute their impact or, worse, offset their premium with other factors. What’s the best way to do this?

Ang: This is a great point. What used to be a question of what (what is a factor) has evolved into a question of how (how to implement them).

We first should take a view on what factors ought to be appropriate for us. We said that a diversified, strategic allocation to multiple factors might be appropriate. You might think about slowly rotating those across time.

Sometimes we might dilute that factor exposure unintentionally, but we ought to maintain that efficiency and maximize that factor exposure.

There are three ways investors should do this.

First, know what you own. Understand the factors that are in your portfolio.

Second, ask if those factors are appropriate for you [based on your goals]. Otherwise, change the mix or change the active managers in your mix.

Third, evaluate how to get from the factors you own today to their optimal by looking across the whole spectrum of investments and vehicles available to you. It's no easy job to be a factor investor. It's hard to imagine mom-and-pop-type investors figuring all this out.

Ang: That's true for all investments. It's very similar to running a restaurant.

If you think about what's required there, you need a recipe, but it also matters how you construct that recipe. You need access to great ingredients, so you want efficient vehicles and the ability to trade efficiently. Then, finally, the chef matters. That's putting all the pieces together.

That's a guideline investors can use—what’s the recipe, what are the ingredients, and who's the chef deciding what mix, and what factor fund to use. And how many dollar signs are on that menu also matters a lot.

Ang: Absolutely. You speak often about factors on the conference circuit. Is there a question about factors or smart beta investing that you get often? Any confusion or myth about the space that just won't die?

Ang: The biggest question I often get is about passive versus active, or alpha versus beta. Those are outdated notions. Everything is an active decision. And factors are certainly the best active investment ideas. We've always had these ideas of buying cheap and finding trends and holding lower-risk securities.

It's not a question of “either/or,” it's a question of “and.” We should be using index and factors and alpha all in our portfolios deliberately. They have different purposes, different levels of transparency and, as you alluded to, different levels of cost. They all play important roles in our portfolios.

Factors are active. We’ve put them into more efficient vehicles and we’ve democratized access to these time-tested sources of returns. The frontier is doing factors in an active way, rotating factors through the business cycle, getting more proprietary and more diversified insights into different factor products.

But let's be clear that factors are active. All decisions of investments, in fact, are active.

Contact Cinthia Murphy at [email protected]

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