Using factor-based investments in portfolios
11 April 2019 | Investing
Matt Gierasimczuk (moderator): Todd, factor-based investing has been growing in popularity globally, but it's still a relatively new concept in Canada. Can you tell us a little bit more about factor-based investing and how it can be implemented in an investment portfolio?
Todd Schlanger (Vanguard senior investment strategist): Sure, as you say, Matt, today there's a lot of different ways where we can actually implement factors in a portfolio; but it's something that's been around for over 50 years in the academic literature. So the way it really came to be was academics thinking about can we break down a portfolio and start to identify the sources of return? So in other words, the market factor was one of the first that academics focused on in that if you're invested in, let's say, a Canadian portfolio of equities or, let's say, a portfolio of U.S. equities, if we compare the performance relative to, let's say, the TSX or the S&P—a broad index fund—we can see a relationship between how the portfolio is performing. And typically the market factor will explain about 80% of the variation we see in returns.
A lot of the talk today is of are there other factors that we can identify that give us even more explanatory power? So in other words, if a portfolio has lower valuations than the market, that would be more a value strategy. If the portfolio has recently outperformed, that would be momentum. If the portfolio tends to trade less, that would be what they call more a liquidity strategy. Or let's say the portfolio is less volatile on average than the market, then that's what's called a volatility or a low vol/min vol type strategy. So these factors give us even more explanatory power in terms of what's actually driving our portfolio returns. You can almost think of them like the DNA of a portfolio, where we can start to break it down.
And I would say there's really two ways that Canadian advisors are using factors. One is getting more transparency in terms of what's driving the portfolio return. So how much of their portfolio's returns are due to the market, due to value, momentum, all these different factors? And giving that transparency—as you say, given that now there's a lot of different ways to implement factors—at a low cost allows them to really look at the tradeoff between what kind of exposure do they want, and then how much are they paying for it.
The second way is that a lot of these factors have been associated with higher risk-adjusted returns. So in other words, if we look over long periods of time, they've produced either higher returns than the market or a higher risk-adjusted return when you compensate for the volatility of the strategy. And so the second way we see Canadian advisors thinking about factors is, if I have beliefs around one of these ways of investing, where either there might be a behavioural anomaly that's resulting in these risk-adjusted returns, or maybe this is generally a higher risk (for some of the strategies) way of investing, they can really target that factor as a source of potential long-term performance.
What we're just educating advisors around on is, one, what's the rationale behind the factors? So that they can start to evaluate in the portfolio. But then, also, that these factors are cyclical. So even though over long periods we can see that they had higher risk-adjusted returns, we know that they've gone through periods of underperformance. So if you want to start to target the factors, you have to be willing to really stick with that strategy when it underperforms as the market goes through different cycles.
Matt Gierasimczuk: That's great. Thanks for being here today, Todd.
Todd Schlanger: Thank you, Matt.
Recorded on October 11, 2018.
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