Factor investing

 There are two principal categories of factors:

• Broad macroeconomic factors – things like real interest rates, inflation, FX (currency movements), policy and tax law changes, and GDP changes; and
• Style factors which are characteristics or attributes of an individual stock that help explain risk and return within a particular asset class – such as value, quality, momentum, dividend yield, low volatility, and relative size.

Investors devote an enormous amount of time, energy and resources in an attempt to better understand financial markets. Studying factors can often help – bringing otherwise invisible things to light. For example, perhaps during past market growth cycles, companies with higher sales growth have markedly outperformed those with higher earnings growth. By combining this observation with another, that companies with higher leverage (i.e., more borrowing) also outperformed, an analyst can more confidently determine that the market is anticipating future economic growth.

While assessing factors is far from revolutionary, the emergence of new technologies and analytics now allow investment managers to conduct more sophisticated in-depth factor analyses (such as looking at the potential impact of multiple factors working together), and to implement factor strategies more quickly in an effort to capture alpha.

Using these new quantitative tools in a thoughtful way, analysts today can do the same work they did years ago using graph paper and calculators – but much more accurately and quickly thanks to automation. A factor tool can accomplish in seconds what might have taken an analyst weeks of work to surmise.

Among institutional investors, allocations to factor-based investment strategies have been steadily on the rise – on average currently comprising 18% of total portfolio value, with assets predominantly being shifted over from traditional active as well as market cap passive strategies.^{Disclosure 1} Furthermore, the same survey shows that nearly half (49%) of institutional investors plan to increase their allocations to active factor strategies over the next three years.

The case for factors

How can factors be used to enhance your nonprofit’s alpha AND reduce overall portfolio risk? “If you know the current trend and direction of those five aforementioned macro variables, you can then go back and look at prior periods where those conditions existed to help determine which asset classes are likely to experience either a tailwind or a headwind,” explains Christopher Komosa, an Investment Advisor with Truist’s Foundations and Endowments Specialty Practice based in Washington, D.C. “For example, if we can confidently assume that GDP growth is accelerating, inflation is stable, both taxes and the regulatory environment are improving, the dollar is stable and real interest rates are falling, then we would expect small cap, growth, U.S. and perhaps emerging markets to outperform in that market environment.”

Once you’ve identified the asset classes you expect to outperform, you can then analyze style factors to identify individual securities within each of those asset classes to build out your portfolio.

In short, we believe that cycles exist and that by using our collective experience and knowledge in understanding what the drivers of a cycle are – essentially a qualitative exercise – we can then use factors as quantitative tools to identify attractive investments.

While it’s true that the growing awareness and adoption of factor-based strategies in the U.S. market has resulted in much of the potential alpha being arbitraged away fairly quickly, there are still merits to the strategy domestically, and tremendous potential to be realized in both established international as well as emerging markets. In addition, more sophisticated factor-based investment managers like Dimensional Fund Advisors (which manages certain portfolioshere at Truist) are increasingly incorporating factor strategies on the fixed income side as well.

All models, even purely mathematical ones, contain subjectivity regarding which factors to include and over what time frame to measure them. We know that analysts are adept at integrating information in order to make relative judgments. Occasionally, however, they lack consistency and allow personal biases to influence their analysis. Factors, on the other hand, are an excellent tool for precision and consistency. The only way they can be fooled is by using faulty data or assuming the future is guaranteed to mirror the past.