Building better portfolios with a factor-based approach

I want to help institutional and individual investors answer the question: How can one build better portfolios? The most important thing is educating investors and clients about important developments in factor-based investment strategies, portfolio construction techniques and active asset management. I think that everything is active since even the choice of the equities and bonds proportion in a portfolio, rebalancing frequency, or the conscious decision for smart beta strategies are active decisions.

 

Asset owners should decide which factors they want to use to challenge their own bad times so this is an investor specific question. I think that disciplined money and risk management techniques in combination with multi-factor investing provide promising investment solutions, but since all depends on investor’s preference, there does not exist a predefined, perfect and optimal mix for factor allocation. This is why reallocating a portfolio towards factor exposure takes time, requires consultation and proper technology.

 

To generate sustainable, transparent, implementable and cost-effective investment results, investors will need to use investment processes based on factors as it is a more efficient way to organize a portfolio using a top down approach. The benefits among others are a more intelligent diversification and the possibility to rebalance factor exposures as required. Factor investing is a strategic choice and can be used to determine what drives returns, to gain diversification benefits, as an alternative to traditional market-capitalization weighted benchmarks and above all as a source of alpha. For investors, factor-based benchmarks represent optimal exposure to risk premia and therefore can be used for strategic asset allocation decisions. These findings are in line with financial theory. However, in the long run, the primary benefit of factor-based investing lies in higher risk-adjusted returns compared to market returns. It is an investment style that involves harvesting a long-term risk premium, but factor investing involves risk as well so sometimes there are short-term losses. The crucial challenge facing factor investing lies in the mindset of the investor, as factors are not always going to work. Sometimes they will fail and sometimes impatient investors will get out right at the wrong time. Factor investing takes commitment, knowledge and patience. 

 

Building better portfolios with factor-based investment strategies helps investors to take a total portfolio view and to consider investments as bundles of factors rather than asset classes. Some of the factors involved are very simple factors and well known such as equities and bonds. These are the extra returns one gets when investing in these markets. Some are more sophisticated dynamic factors such as size, value, momentum, profitability and low volatility, to name a few.

 

My job has been to deliver outstanding investment returns by applying groundbreaking scientific research. One of the key aspects is the dynamic construction of portfolios and this is where portfolio manager skills count most. When considering any active strategy, investors should have a clear understanding of the sources of expected returns, the stability and sustainability of those returns, the risk exposures and risk controls, the liquidity demands of the strategy and whether the management costs are commensurate with expected results.

 

 

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