A growing number of investors have begun using a factor-based investment approach when constructing their portfolios. Supported by academic research, factor-based investments can offer attractive returns and often carry lower fees. So far, many offerings limit themselves to one factor within a “long-only” investment strategy on single stocks. However, the underlying drivers of factors are universal so the factors are present in other asset classes as well. If one can successfully capture these factors, one can harvest attractive return sources that provide true diversification. Therefore we see Multi-Asset factor investing as a valuable addition to portfolios.
UNDERSTAND THE FUNDAMENTALS
Factor investing originates in the academic society, where in recent decades extensive research has been published showing the existence of factors and their attractive and diversifying returns.
The existence of factors can be explained by three distinct drivers:
(i) Compensation for risks that other investors want or need to transfer;
(ii) Behavioural biases of investors causing assets to be “mispriced”;
(iii) Compensation for providing liquidity in case of a supply and demand imbalance.
By having a detailed understanding of these fundamental elements that drive returns, one can develop smart investment rules that capture these attractive return sources.
For instance, momentum (factor) can be attributed to the herding behaviour of investors (driver). This behavioural bias causes investors to become more positive on an investment if other investors are positive as well, which causes prices to continue to go up (and vice versa). One can bene t from this phenomenon by buying the winners, that is, the investments with a positive return, and selling the losers, or those with a negative return. This strategy has provided attractive returns over the long run.
We expect factors to continue to have positive expected returns going forward as the above-mentioned26 drivers are not likely to evaporate. Investors always want to be compensated for taking a risk, human behaviour generally does not change, and investors’ objectives and restrictions will continue to generate supply and demand imbalances.
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