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.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.
By employing a multi-factor investment approach, nonprofits may not only increase the likelihood of generating excess future returns, the added diversification serves to mitigate the overall portfolio risk – protecting against any one single factor acting contrary to expectation. At Truist Wealth, we employ quantitative factors alongside more traditional methods of analysis to identify attractive investment solutions for our clients.
New factors emerging: ESG
In many respects, factors are akin to secluded beaches or hidden surf spots – the more they become widely known and adopted, the lower the expected benefit you will derive from them. For this reason, investment managers are continually searching for new factors that might give them added insights.
Environmental, social and governance (ESG) factors – a consideration that’s front and center in the minds of a great many nonprofits – is one of these areas of emerging interest and discussion. Several studies conducted in recent years point to ESG factors as a valuable tool for managing portfolio tail risk, particularly during times of high market volatility:
- A comprehensive ESG analysis of all U.S. stocks (from 2007 – 2017) determined that stocks scoring highest for ESG metrics (top quintile) outpaced those scoring lowest on ESG metrics (bottom quintile) in each of the four worst performing years for the stock market; including a sizable 13.5% performance spread in 2008 during the height of the financial crisis.2
- Research from data provider Morningstar examining the long-term performance of a sample of 745 sustainable funds, shows that a majority of ESG strategies have outperformed non-ESG funds over one, three, five and 10-year periods.
There’s a growing body of evidence to support the belief that ESG factors such as good governance and greater organizational diversity lead to better company results. It’s an area we continue to pay particularly close attention to at Truist, as we seek out best-in-class factor managers to partner with us.
Factor investing in a post-COVID world
The hard truth is that we are going to be in a post-COVID world for a long while – perhaps years – and as a result, everything in this market cycle is going to be impacted. Any economic recovery is likely to be drawn-out and extremely uneven. Unlike in the aftermath of the 2008 financial crisis, the next rising tide won’t lift all boats, so security selection is going to take on even greater importance.
We need to look closely at which factors will likely be most critical to continued success in this post-COVID world.
At Truist, our Foundations and Endowments Specialty Practice is committed to being on the cutting edge of strategically and tactically using factors to manage your nonprofit’s portfolio in a way that reflects your investment objectives, capital and liquidity needs, and appetite for risk – overlaying macro factors to identify the optimal mix of managers for you.
While we employ factor analysis in a great deal of what we do, to enhance your alpha while also mitigating your investment risk, it’s also essential to incorporate a thorough qualitative assessment into your investment decision-making process. Quantitative tools like factor analysis can be incredibly useful, but only when paired with an attentive, common sense appraisal of the macroeconomic landscape.