Understanding these elements and their implications can be critical to determining how a factor-based strategy may respond in different market environments and in various scenarios. Advisors can also use factor load analysis to better understand the exposures afforded by a particular approach and what is driving the return.
What to Consider Before Implementing a Factor-Based Strategy
1. Before putting a factor-based strategy to work in an investment portfolio, seek to understand its methodology, but also think through the possible implications of that methodology. How would it fare under exceptional circumstances such as the crisis of 2008 or the collapse of the technology sector in 2000? Does the strategy deliver what is intended?
2. Avoid taking results at face value; instead, use factor load analysis to dig deeper into any strategy before drawing strong conclusions. Recognize that single-factor strategies will be periodically impacted by exposure to other factors. Regular rebalancing, however, will systematically help to ensure the strategies stick to their mandate.
3. Understand that while the factor based on historical research is expected to generate excess return and reward investors over full market cycles and across long time horizons, factors are cyclical and may underperform over varying time horizons. Diversification across rewarded investment factors can help, given the low to negative correlation of excess returns among factors that has been observed over long periods of time. The availability of single-factor strategies delivered through an ETF make this approach straightforward and actionable.
John Feyerer is vice president and director of equity strategy at PowerShares by Invesco.