How to Build a Factor-Based Investment Portfolio?
Are you keen on learning about a factor-based investment portfolio? Are you bombarded with several questions regarding the same? Then, we’ve got you covered! This post will address all your queries and clarify your doubts.
Due to innovations and technological transformations, there has been a paradigm shift in the asset management industry, especially over the past decade. A plethora of investors has become more systematic in terms of portfolio construction as well as implementation. However, among the most emblematic changes is the emphasis on ‘factor investing’, which has remained at the top-of-the-mind of various investors.
In this post, you will get to know about how you can build an effective factor-based investment portfolio. However, before that, it is important for you to first know what exactly is factor investing, what are its challenges, and how can it improve your portfolio. So, let’s get started!
What Is Factor Investing?
Factor investing lays its foundation on a very strong idea that factors are the ultimate building blocks of an investment portfolio. It is a simple strategy that prioritizes securities over attributes, which actually leads to maximum returns.
By analyzing various factors, such as market capitalization, stock price volatility, or credit ratings, factor investing can assist you in building the right investment portfolio and strategy so that you can outperform the market with extensive positive outcomes. Choosing factors that have a long history of providing effective results is extremely pivotal to keep things beneficial.
What Are The Challenges Of Factor Investing?
Targeting the right factors has become one of the most powerful strategies of investors over the past few years. However, do you know what challenges you could face while integrating the concept of factors into the investment process? Let’s have a look at four major challenges:
Challenge 1: Targeting The Meaningful Factors
It is not an easy task to identify as well as recognize the factors that are intended to provide you with premium returns. Neither is there any single approach to do so. The factor allocation process depends upon various other factors such as the investor’s profile, the risk appetite of the investor, or expectation in terms of the performance. Moreover, choosing which factor or set of factors is worthy for the portfolio is still an on-going debate among different investors.
Challenge 2: Implementation of Factor-Investing Decisions in a Cost-Effective Way
If the implementation of your decisions can break your bank, then it may not provide you with the profit that you always desire. Hence, you need to implement the factor investing decisions taking care of the finances. But, this can turn out to be a huge challenge.
Challenge 3: Identifying the Right Strategy
There has been a great diversity and extent when it comes to investing strategies, but the right strategy is what makes the investors find their ways. However, identifying the right strategy is a big challenge. Whether one needs to follow a classic strategy, a traditional strategy, an active strategy, a passive strategy, or any other one – investors always struggle while making such decisions.
Challenge 4: Avoiding Major Pitfalls
Investors struggle in avoiding the products or services with major pitfalls. Even though they capture effective and premium factors, they are usually exposed to unrewarded risks and clashing factors. Some products or services do well with one factor, but as they are exposed to the other one, things go towards the negative side. And as a result, there is a negative exposure to the product or service as well as a constant clash between various factors. Avoiding them becomes a challenging task for many investors.
How Can Factor Investing Improve Your Portfolio?
Now let’s discuss some of the advantages of factor investing.
- Improved Indexing: In the factor investing approach, effective indexing strategies are designed in a systematic manner to capture the market returns and to draw out maximum benefits from premium factors. This approach renders portfolios with great flexibility and tracking ability so that the investors can create benchmarks in a more consistent way.
- Enhanced Diversification: Single factor-based portfolios may lead to disappointing performances in terms of market benchmarks. A multi-factor strategy is certainly a balanced approach to investing. It gives you a broad exposure while preventing the major and common pitfalls. In doing investment this way, you can aim at high as well as meaningful factor exposure, thus leading to a strong Sharpe ratio.
- Reduced Volatility: Various factors have pushed many investors to opt for highly effective ways to reduce risks in their portfolios without compromising on the returns. Therefore, factor investing can prove to be a boon for the investors because it tends to fall less during downturns and generates higher returns while adjusting to the risks.
How to Build an Effective Factor-Based Investment Portfolio?
Basically, there are five prominent ways through which you can effectively construct your investment portfolio:
- Understand Various Factors: Before starting to build an effective factor-based investment portfolio, you need to first gain an in-depth understanding of various factors. Equity factors are related to the company’s size as well as style (growth or value). Risk factors include those, which can explain risks and returns. Fixed income factors consist of credits, interest rates, and prepayment risks. Besides, factors also include various macroeconomic variables, for example, inflations and commodity prices.
- Diligent Revising: Understand the factor exposures in terms of a previously determined investment portfolio and revise your factor allocation process accordingly. This is a simple methodology that will assist you in gaining a great understanding of the factor exposures.
- Assessing The Risks/Risk-Based Allocation Method: Choose the model that can analyze your portfolio risk exposures as well as can project future risks. By using the risk decomposition method, you can identify how much and what types of risks are present in your portfolio.
- Assessing The Performance/Result-Based Allocation Method: Choose the attributes that can explain the sources of your returns from the portfolio. Always follow a return-oriented approach while building investment portfolios because this will allow you to analyze its future performance.
- Factor Tilting Method: This is probably the most widely used method while creating portfolios. In this method, you need to actively tweak your portfolio’s exposure to certain factors. The process of tweaking will be carried out on the basis of existing factor allocation.
- Equally-Weighted Portfolio: This is one of the most popular factor allocation strategies that follows a rule denoted as EW. This rule assigns equal time-invariant weights to each one of the factors.
- Empirical Analysis Of Factors: With the help of various statistics and conditional analysis of the data, you can check out whether or not your factors are robust to outperform in the market. If your factors fail in such types of robust checks, then you can try optimizing or adjusting them according to your requirements.
- Mixed Allocation Methods: If you feel that one method is not providing you with optimum results, then you can also combine two or more methods to follow a more diversified approach while creating your portfolio. A mixed-method strategy will certainly double the positive outcomes as well as the effectiveness of your portfolio.
Core Foundations of Factor Investing To Consider While Building a Portfolio
- Value: The primary aim of value is to extract out maximum returns from the stocks that have relatively low prices.
- Size: A cursory glance at the history shows that portfolios containing small-cap stocks provide greater returns than those with large-cap ones.
- Momentum: Having a great momentum means exhibiting strong returns while going forward in the future.
- Quality: Stabilized earnings, lower debts, consistent growth, and strong returns – they all determine the quality of your portfolio.
- Low Volatility: If your portfolio is designed while keeping in mind the low volatility, then it possesses a great ability to deliver risk-adjusted returns.
The Bottom Line
In this competitive world, investors should always choose appropriate ways to capture premium factors in their portfolios. If done accurately, a factor-based investment portfolio can deliver you cutting-edge and positive solutions such as mitigating your risks and boosting the long-term returns.
Don’t have time or knowledge to build and manage a factor-based investment portfolio? If so, leave everything to us!
We at Wealthface are proud financial consultants of businesses across the globe. Over the past few years, we have companies and individuals in building their investment portfolio. We analyze each of our clients and then suggest a customized investment portfolio strategy. Our dexterous crew of experts is here to help you out so you may reap long-term returns while eliminating potential risks.