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.
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
Source: S&P 12/31/2017
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, 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.