Portfolio management has evolved tremendously in response to new findings by academia, technological advances and the explosion of information. The latest step in this evolution may be factor-based investing. According to BlackRock, factor-based strategies may reach $3.4 trillion in assets under management by 2022, up from today’s $1.9 trillion.¹

What is Factor-Based Investing?

Most investment professionals have been taught that there are two basic sources of investment returns: beta (what the market gives you) and alpha (additional return that can be extracted through skill and knowledge).

It may be time to add a third source of investment return—enhanced beta.

Advisors know that broad economic factors—such as GDP growth rates, inflation or interest rates—will account for much of stocks’ performance across asset classes and styles. However, academic research has shown that there are five factors that drive the long-term returns of individual stocks within an asset class. They are:

• Market Capitalization
• Value
• Momentum
• Low Volatility
• Quality

A recent research report, “The Merits and Methods of Multi-Factor Investing,”² found that incorporating one or more of these factors into the development of a portfolio may enhance the overall long-term returns, while reducing portfolio volatility.

While a single-factor approach may deliver higher risk-adjusted returns than an overall index, the natural rotation of leadership among these factors over time suggests that a multi-factor approach may be more appropriate for individual investors.

Among the findings published in “The Merits and Methods of Multi-Factor Investing,” the S&P 500 Momentum Index, for instance, outperformed the S&P 500 Index in only 45.9 percent of all rolling five-year periods since 1994, while the S&P 500 Low Volatility Index managed to outperform in 87.7 percent of all five-year rolling periods. However, a multi-factor approach of Quality, Value, Momentum and Low Volatility outperformed the S&P 500 Index in all of the rolling five-year time frames (as well as in all 10- and 15-year rolling periods).³

A factor-based strategy may take the form of a smart beta fund, proprietary-driven factor model or one employed within the context of a multi-asset or long-short fund. For advisors in search of new ideas and methods to meeting their clients’ long-term investment needs, they may want to further explore this new, factor-based approach in building investment portfolios.

Sources:

1. https://www.blackrock.com/investing/investment-ideas/what-is-factor-investing/factor-commentary/andrews-angle/factor-growth
2. “The Merit and Methods of Multi-Factor Investing,” Andrew Innes, S&P Dow Jones Indices, April 2018
3. “The Merit and Methods of Multi-Factor Investing,” Andrew Innes, S&P Dow Jones Indices, April 2018

See referenced disclosure (2) (3) at https://blog-dev.americanportfolios.com/disclosures/