When I think of the apex of customization, my mind is immediately drawn to 7-Eleven, which became the first major retailer to offer self-serve fountain drinks in 1983. Up until that point, a customer ordered their soda, and someone behind the counter would fill it. But that glorious day in the early ‘80s marked the birth of the Graveyard—also known as the Suicide in some states—a mixture created just for the customer, with whatever mix of carbonated beverage they liked.
Similar to beverage customization, investment customization has come a long way. Security selection is perhaps the best-known advantage of a customized separately managed account (SMA). Investors may be less familiar with the ways they can tailor their portfolios for yield enhancement. Let’s take a look at two key approaches.
How can investors use factors to enhance yield?
Using equities to customize for yield enhancement isn’t a completely new invention. Investors have had access to a variety of dividend-focused strategies for years. One specific way to get access to yield enhancement is to use a dividend factor strategy. Factor investing is an investment approach that involves targeting quantifiable firm characteristics, or factors, that can explain differences in stock returns. A few other popular factors besides dividend yield include momentum, value, and quality. A factor-based investment strategy involves tilting equity portfolios toward and away from specific factors in an attempt to generate long-term investment returns in excess of benchmarks. The approach is quantitative and based on observable data, such as stock prices and financial information, rather than on opinion or speculation.
This type of strategy is ideal for investors with a long-term focus and a willingness to accept higher risk in pursuit of higher excess return potential due to the factor risk premium. When used on a standalone basis, our research estimates the predicted tracking error of a factor strategy to be between 3% and 6%. Many investors blend factor strategies with a broad-based cap-weighted benchmark in order to bring that relative risk down. A factor-based strategy is also suitable for investors who want to replicate the risk characteristics of an active portfolio without paying active management fees.
Building portfolios that attempt to maximize the investor’s exposure to a specific factor may bring along bets that certain investors might not be aware of. Focusing on dividend yield exclusively will tend to build portfolios that overweight certain dividend-paying stocks in financials, industrials, and energy. This is why some factor-based strategies provide investors with the ability to maximize certain factor exposures while still constraining the unintended exposures that come from that type of investing.
How can investors use options to enhance yield?
Another way to capture yield enhancement in a customized portfolio is through the use of options. Using options to enhance the return on the portfolio’s underlying assets has been an often-used strategy since listed options started trading in 1973, a decade before customized beverage pouring came into vogue. An investor who buys options is essentially buying insurance. Most people who buy homeowners’ or auto insurance take it for granted that the insurance company includes a profit margin, or risk premium, into the price of the insurance. We see a similar dynamic in the options market: Option buyers are willing to slightly overpay, which offers option sellers the potential for collecting a risk premium.