Get Comfortable with Being Uncomfortable, Part 3: Factor Investing

This is the third and final post of a three-part series we’re affectionately calling “How to Get Comfortable with Being Uncomfortable.” The series covers the tremendous headwinds investors in traditional portfolios are likely to over the next decade or more, and the steps required to turn a bad situation into a great opportunity.  These steps – set realistic expectations, diversify as much as you can handle, and take advantage of others’ mistakes with factor investing – are designed to help investors through whatever the future holds.

Reminder: When Valuations Are High, Diversification is King

In Part 1 of this series, we addressed how US stock and bond valuations remain extremely lofty. As a result, it is unrealistic to expect the portfolios that investors have grown comfortable with over the past few decades to produce the returns investors need to achieve financial independence.  In fact, after adjusting for inflation and fees, we estimate that investors will be hard-pressed to earn more than 2% per year on traditional portfolios of domestically focused stocks and bonds over the next decade.

For those looking for alternatives to working longer, saving more, or lowering expectations about their retirement lifestyle, we then established that maximum diversification offers attractive benefits.  Diversification is first and foremost about “diversity”, which means holding a broad array of assets from all major economic regions of the world. This is especially advantageous in the current environment because non-traditional assets like emerging market stocks and bonds have higher current prospective returns. Diversification is also about “balance”, which results in substantially less risk for diversified portfolios. However, because diversified strategies such as risk parity have different risk/return profiles than long-established faux-balanced portfolios (such as the US 60/40), they inflict a different type of discomfort. To attenuate feelings of regret, especially when your domestic equity market is leading the charge, we recommend diversifying as much as your emotions can handle.

What is Factor Investing?

It is well known that investors in every country around the world have a strong preference to own the stock and debt of their own domestic companies. This home bias is one of the strongest and most pervasive effects in markets. Many investors also express a preference for “lottery ticket”-type investments, and investments that are popular or appear to have a good “story.” Investors also take comfort in holding portfolios that are consistent with their peer group because the pain of underperforming their friends is much more intense than the joy of outperforming them. Investors are often slow to adapt to new information, and are prone to extrapolate near-term trends while underestimating the tendency of corporate prospects to revert to the mean. These behaviors are universal, and are observed at the highest ranks of the most sophisticated organizations. Most investment capital is still guided by humans, and humans can be counted on to consistently behave in certain ways.

It turns out that the systematic errors above manifest in economically large effects across global markets. These effects, which are called “factors,” explain a very large portion of the differences in returns across groups of securities. If a large portion of investors can be counted on to behave in ways that leave profits on the table, then there is an opportunity for other investors – factor investors – to earn excess profits by taking the other side of those trades. And these excess profits can be very attractive for several reasons.

The Benefits of Factor Investing: It’s Profitable and Uncorrelated with Traditional Asset Classes

First of all, these profits can be quite large. When the most robust factor effects are harvested across a diverse basket of global market indexes and securities, they have produced returns of between 9% and 13.7% per year, when scaled to about the same risk as a global balanced portfolio (Figure 1).

Figure 1. Annual excess returns to long-short global factor portfolios scaled to 10% annualized volatility, 1990 – 2012

Source: Ilmamen A., “Better Diversification in the Low Expected Return World”

Second, their returns are unrelated to the returns of traditional assets like stocks and bonds. In fact, on average they have near-zero correlation to both equities and bonds. This means that, when they are added to a traditional portfolio, they are likely to add to returns while reducing overall portfolio risk. This concept is illustrated in Figure 2, which is a stylized efficient frontier. It describes the return of the most efficient portfolio at each level of risk. The inclusion of factors moves the traditional frontier substantially up and to the left, implying both higher returns and less risk.

Figure 2. The “New Frontier” including factors.

Source: ReSolve Asset Management. For illustrative purposes only.

Unfortunately, Factor Investing Isn’t Easy

So far, we have focused on the benefits of adding factor strategies to traditional portfolios. But, as mentioned above, factor strategies have their own set of discomforts. Remember that factor strategies work because they require investors to act against human nature. In other words, they are often counterintuitive.

Consider a global value strategy that systematically sells stocks in countries with high valuations to purchase stocks in countries with extremely depressed valuations. At the end of 2016, this strategy would have mandated selling out of U.S. stocks to purchase stocks in countries like Russia, Turkey, and the Czech Republic. Many investors would find it difficult to divest of shares that have treated them so well for the past 10 years, to purchase stocks in countries that are embroiled in war or economic turmoil.

Another reason why investors should tread lightly into factor strategies is that they behave very differently than what investors expect from traditional portfolios. For example, some strategies deliver very steady and strong returns for years at a time and then give back a large portion of returns in an acute and unexpected crisis. Some factor strategies have a history of performing at their absolute worst in periods when traditional portfolios are experiencing their best gains. These character quirks make it challenging for many investors to stick with these approaches in concentrated positions.

Layer Factor Strategies On Top of Traditional Sources of Return

In addition to issues of comfort, many investors have financial constraints that make it difficult to invest in pure factor strategies. For example, many factor strategies require leverage and shorting to produce returns that are competitive with equities. For this reason, it often makes more sense to overlay a factor strategy directly on top of a long-only asset allocation. That way, investors can benefit from long-only exposure to traditional sources of investment growth, like global stocks and bonds, while using factor strategies to improve diversification and enhance returns.

It is easy to deploy factor-based strategies within target asset classes like stocks or bonds, or even across many global asset classes at once with multi-asset strategies. The iShares Edge MSCI Diversified Multifactor Global ETF (ACWF) is a great example of the former. This index seeks to maximize total aggregate exposure to the most powerful factors – low size, value, momentum, and quality – while preserving the same risk character as a diversified global equity index. As a result, the index has produced substantial excess returns relative to its market cap weighted benchmark since inception in 1998.

Figure 3. MSCI ACWI Diversified Multi-Factor Index vs. MSCI All-Cap World Index

Source: ReSolve Asset Management. Data from iShares.

Factor tilt strategies within target asset classes have the advantage of allowing investors to preserve their strategic asset allocation. In addition, by diversifying across several dimensions of risk and return, multi-factor strategies typically exhibit lower tracking error, making them easier to stick with than single-factor products. The MSCI index above has produced higher returns than its benchmark over 80% of rolling 12-month periods and 84% of rolling 3-year periods.

However, it’s clear from the table in Figure 3 that, while target asset factor strategies can produce higher returns than related cap-weighted indexes, they exhibit the same risk character as their underlying asset class. For example, the MSCI factor strategy produced the same loss (~55%) as its market-cap weighted benchmark in 2008.

Multi-Asset Factor Strategies to The Rescue

Over the last few years, and especially since the Gobal Financial Crisis in 2008, investors have been turning to multi-asset strategies to deliver the returns they need, but with the potential for much less risk. Unlike target-asset factor strategies, multi-asset strategies can make use of a much wider array of asset classes in order to produce steady returns in most economic environments.

There are a variety of ways to implement multi-asset factor strategies. We covered one such strategy – Global Risk Parity – in Part II of this article series. In fact, the ReSolve Global Risk Parity strategy combines the concept of risk parity – already compelling on its own – with a tilt toward the multi-asset momentum factor. Specifically, the strategy systematically allocates less risk to assets in persistent negative trends. As a result, the ReSolve Global Risk Parity Index has produced very attractive results over the past 25 years, across even hostile market environments, and with a modest risk profile. Click here to learn more about multi-asset factor strategies.

Figure 4. ReSolve Global Risk Parity Index

Source: ReSolve Asset Management. Index calculated by S&P Dow Jones Indices. Methodology by ReSolve Asset Management. Please see disclaimers. Past performance is not indicative of future results.

Putting it All Together

It’s important to remember that “risk” is the probability that clients won’t meet their financial goals. Advisors should have the singular objective of minimizing this risk. This definition of risk expands the concept to include not just the prospect of short-term losses or volatility, but also the need to generate sufficient returns in all market conditions.

Unfortunately, with low yields on fixed income and elevated valuations for North American equities, investors are unlikely to achieve their desired returns from investments in traditional portfolios. Investors face less comfortable choices now than in the past. Some investors may choose to stay the course with their investments while saving more, working longer and reducing expectations about their lifestyle in retirement.

Others may choose to explore alternative ways to construct portfolios. To protect against a highly uncertain future, investors might explore extreme diversification methods, which offer exposure to asset classes with better return prospects like frontier markets and emerging market government bonds. Others may seek higher returns and the potential for lower risk by allocating to alternative return premia – factors – that arise from other investors’ mistakes and alternative preferences. Long-only multi-asset strategies like the ReSolve Global Risk Parity and Adaptive Asset Allocation strategies may offer the best of both worlds for many investors with typical constraints.

None of these choices is without risk or discomfort. It is uncomfortable to save more and retrench. Diversification is uncomfortable when an investor’s home equity market is on a hot streak. Many factor strategies produce returns in unconventional ways, which can catch inexperienced investors off guard.

The point is this: If investors want successful financial outcomes in coming decades, they need to get comfortable with being uncomfortable.