Factor investing seems like a newfangled concept to many investors. In reality, it has been around for decades in academic research, and work on the topic has collected five Nobel prizes. The genre, if you will, only seems new-ish after a plethora of factor-focused ’40 Act funds aimed at retail investors launched in recent years. So it’s still a nascent—if not nebulous—area for many investors and perhaps some financial advisors.
And if you’re not careful, it’s easy to get lost in the weeds in this investing patch. According to Andrew Ang, a managing director at BlackRock spearheading the company’s efforts in factor investing, an article in the Journal of Finance last year identified 316 factors. But mercifully, Ang said during his one-man presentation at last month’s Morningstar ETF Conference in Chicago, investors need to focus on just a handful of factors. And these are the ones most commonly found in investable products.
As defined by BlackRock, factors are broad, persistent drivers of return. Among the most prevalent factors used in investing circles are a company’s quality (its financial health); momentum (the relative strength of its performance); value (how inexpensive it is relative to its fundamentals); size; and volatility (which, if lower, indicates that it’s a lower-risk stock).
As Ang explained, factors can have three different purposes within portfolios: You can use them to choose names that complement existing holdings; you can use them to replace existing holdings; or you can express views on market conditions, which is also known as factor tilting (or timing, if you like).
In analyzing stocks that complement each other, Ang said BlackRock usually finds one or two factors that tend to dominate—value and momentum, and in a minority of cases, both do. But investors shouldn’t neglect other factors that can promise return, such as companies’ low volatility and quality. “We can add factors that we don’t have, and as we add broad and persistent other sources of return we’ll improve the diversification and robustness or our portfolios,” he explained.
The first step is understanding the factors you currently hold, then looking at those that might complement your existing holdings. For example, as noted above, investors often have value portfolios or portfolios focused on growth (i.e., momentum).
“Value and momentum are negatively correlated, and that negative correlation is beautiful for being able to build a well-diversified portfolio,” Ang said.
But if you’re not careful, sometimes these factors will cancel out each other in your portfolio construction. “Not all portfolio construction factors are created equal,” he added.
If investors want to use factors to replace current holdings, Ang said the new ’40 Act funds have allowed them to unbundle or offset exposures they didn’t intend to hold or that they have a negative view on.
The third leg of the stool, factor tilting, helps investors express their views as they go through the business cycle.
“One way to think about factor cyclicality is by harvesting that cyclicality, or tilting,” Ang said. “It’s not short-term, global macro-style in-and-out timing. Instead, you start out with a well-diversified combination of those factors and then slowly rotate your portfolio around them.”
What signals can be used to tilt those factors?
Citing the second quarter edition of BlackRock’s “Factor Outlook” report, Ang said the company is bullish on momentum, which has strong relative strength. In other words, there’s momentum on momentum. “We see valuations being fairly attractive for momentum,” he offered. “We see an expanding but slightly slowing-down form of economic expansion.” Factor tilting, he added, is a noncorrelated source of returns.