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Navigating the Hidden Pitfalls of Factor Investing


Many investors consider creating factor portfolios tilted toward particular stock characteristics, such as valuation, company size, price momentum, dividend yield, low volatility and profitability, with the hope of realizing long-term outperformance. While it can be tempting to reweight your portfolio using such factors, there are inherent risks—which include the unintended bets you may be assuming.

Accessing factors

One way to access factors is through index providers that often use simple and transparent rules to construct factor portfolios. While simplicity and transparency are good attributes, these rules-based approaches suffer from an important drawback. They are not risk aware. As a result, factor-based indexes often contain unintended country, sector and style bets relative to the broad market index. These are side effects of the portfolio-construction process.

Know what you own

For example, low-volatility indexes are often concentrated in utility (20.6% in the S&P 500 Low Volatility index vs 2.9% in the S&P 500!) and consumer staples companies; value indexes tilt toward unprofitable companies; dividend indexes have large sector concentrations; and, when a factor becomes popular, the price multiples associated with those stocks can become elevated relative to historical levels. These unintended bets can have a significant impact on portfolio returns—one of the major pitfalls associated with factor investing.

Low Volatility Can Have Unintentional Sector Bets

S&P Chart

Source: S&P 12/31/2017

How you can avoid these pitfalls

We believe it is important to closely monitor and manage risks, especially when considering a factor-based index. Adding constraints can help reduce unintended sector, country and factor bets, but this approach does come at a cost. For example, adding constraints reduces your exposure to the intended factors. However, our research shows that factor efficiency is actually improved when constraints are added—the factor-exposure-to-tracking-error ratio goes up and the portion of active risk due to the intended bets increases. 

Why high factor efficiency matters

A key benefit of higher factor efficiency is that investors are more likely to stick with this type of strategy during the inevitable periods of underperformance. Investors gain some comfort if poor returns can be attributed to intended active bets that are currently out of favor. Underperformance coming from randomness or from unintended active bets is more alarming to investors and can lead to abandonment of the strategy. Strategies with higher factor efficiency are more likely to retain investors over longer periods, helping them earn the associated factor-risk premiums.

Bottom line

This is not a new issue—portfolios of stocks built from any sort of bottom-up stock selection process contain unintended country, industry and factor exposures. Common practice among investment managers is to control these unintended bets. For example, by imposing some sector diversification (or constraint) on the stock-selection process. Often these constraints are viewed as a necessary evil, required to make the portfolio accessible to investors. In contrast, we believe constraints are a critical part of the investment process, as they reduce the noise and amplify the signal for factor-based strategies, which can help you avoid the unintended pitfalls.

Potential Parametric Solution

Our Factor Investing Strategy is designed to help clients keep more of their investment return through efficient implementation and systematic tax management, if applicable. Our Custom CoreTM accounts can also leverage factors, allowing clients to customize portfolios to their needs. Investors can select from a wide range of benchmarks and then tailor their exposures to incorporate their unique objectives.

Paul Bouchey

Paul Bouchey, CFA - Chief Investment Officer

Mr. Bouchey leads Parametric’s investment, research and strategy activities. His research interests include indexing, tax management, factors, and rebalancing. Paul earned a B.A. in mathematics and physics from Whitman College and an M.S. in Computational Finance and Risk Management from the University of Washington. He holds the Chartered Financial Analyst designation.

The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.