Investors are taking too much risk and not thinking about investment factors when creating their portfolios, whether they are a big sovereign wealth fund or a small investor, said Michael Hunstad, head of quantitative strategies at Northern Trust Asset Management.
Hunstad said he knows this is the case because 85 percent of the clients at Northern Trust fall into this category, taking significant risks with their portfolio. But by targeting certain factors, investors not only can lower their overall risk, but also boost returns, he said.
He spoke at the Wealth Advisor Forum Monday in Chicago.
Hunstad said while everyone invests in factors in some way—investors are exposed to factors just by using the Standard & Poor’s 500 stock index—they’re not always doing so actively or advantageously. Investors need to think about using factors by considering risks and how to be compensated for that risk, he said.
“Factors add another layer of granularity and allow you to express your tactical and strategic views. Our most sophisticated investors are using them as building blocks to get the results they want,” he said.
The factors he looks at are classic, academically studied factors: high quality, value, low volatility, dividend-payers, size and momentum.
He said most portfolios include factors only passively, without an active strategy. Many portfolios are built keeping a balance of beta, or equity-risk premium, and alpha, or stock-picking ability. Without using factors, investors are missing out on greater potential excess return, he said.
He cited a 1997 study by Mark Carhart of University of Chicago that looked at mutual fund performance over 30 years. The research found that of the mutual funds that outperformed, on average, 6.6 percent of the return was from factors, while minus 1.56 percent was from stock-picking ability, for a net return of 4.94 percent.
When financial advisors start to use factors, they need to be intentional about how they are using them, he said. Hunstad gave two examples of using factors in asset allocation with a tactical approach. When advisors look at their macroeconomic views, such as their views on growth, inflation, monetary policy or other economic issues, they will express those views by investing in equities, debt, real estate, etc. To add factors, consider which factors do well in the expected environment, he said.
Each scenario offers "a variety of factors to be used as granular levers to adjust the outcome,” he said.