Incorporating style factors into a diversified investment portfolio can be an effective long-term strategy. While there may be positive and negative periods in the performance of style factors, research has shown that using these factors over the long term can produce higher risk-adjusted returns. Therefore, investors who trust in the long-term benefits of style factors may be able to achieve superior returns by including these characteristics in their investment portfolios.
Investors who use style factors in their investment strategies and maintain their exposures to these factors over long periods of time may be able to capture the factor risk premium, or the excess returns that have been shown to be associated with these characteristics. By continuously investing in style factors, investors can benefit from the diversification and low correlation of these strategies, even during periods of underperformance. Style factor investing is therefore best suited to a long-term investment horizon and should be considered as part of a diversified portfolio. It is important to hold style factor portfolios for extended periods in order to ride out any periods of underperformance that may occur and to take advantage of the historical performance of these factors as a guide. It is also advisable to consider holding a blend of multiple factors in order to benefit from the diversification of various uncorrelated strategies.
Cumulative performance plots of some style factors compared to MSCI World Index. Source: MSCI
Risk-adjusted Returns
For many investors, risk and return are key considerations in investment decisions. Investors may have a maximum level of risk that they are willing to take in pursuit of returns, and may therefore be interested in strategies that can lower overall risk while still achieving satisfactory returns. Style factor investing can be a useful tool for achieving this goal, as it allows investors to group stocks together based on common characteristics that may offer the potential for high risk-adjusted returns.
Risk-adjusted returns are a measure of the returns achieved by an investment relative to the risk taken to achieve those returns. For example, a portfolio that generates a 20% annual return with a volatility of 40% annualized would not be considered as attractive as a portfolio with the same return but a lower volatility of 10%. One way to measure risk-adjusted returns is through the use of the Sharpe ratio, which scales returns by the risk taken to generate those returns and takes into account the risk-free interest rate. The formula for the Sharpe ratio is:
Sharpe ratio =(Average portfolio return - Risk-free interest rate) / Standard deviation of portfolio returns.
By using risk-adjusted return metrics like the Sharpe ratio, investors can compare the performance of different investment strategies and determine which ones offer the best risk-to-return trade-off.
The rolling 1y sharpe ratio for the S+P 500 during the post global financial crisis period
Long Style Factor ETFs vs Market-Neutral Style Factors
Investors who want to use style factors to build a quantitatively-driven investment portfolio have two main options: they can construct a traditional long-short, market neutral portfolio that has low correlation to the overall market, or they can form a long-only portfolio that tilts their portfolio towards the factor while maintaining long market exposure.
Long-only factor portfolios, which are similar to smart beta strategies, are popular with both retail and institutional investors, particularly those who are benchmarked to market indices. However, a study by Robeco called "When Equity Factors Drop Their Shorts" analyzed the performance difference between long-short and long-only factor investment strategies, and found that long-only factors may not perform as well as traditional long-short strategies.
To create a more market neutral long-short portfolio, the study also used a natural pseudo-short approach, which involved selling an index ETF such as the SPY to create a short side alongside the long factor portfolio. This allows investors to create an overall market-neutral factor portfolio if desired. It is important for investors to carefully consider their investment objectives and risk tolerance before deciding on the most appropriate style factor strategy.
An investor's decision to use a long-only factor strategy or a long-short strategy may depend on factors such as the desire to generate absolute returns, the availability of leverage, and the ability to short sell.
Generating absolute returns through diversified strategies that can generate returns independent of market direction
Using leverage to amplify potential returns
Being able to short sell with the permission of a broker or in countries without short-selling restrictions
Outperforming a benchmark index
Allocating portfolios towards concepts or factors that the investor believes in
Always wanting to be invested and using the entire risk budget
Factor timing involves adjusting exposure to factors based on how the investor expects them to perform in the future. This can be done through discretionary weighting or by using a quantitative model to shift factor weights. While factor timing can be difficult to implement successfully, some studies have suggested that it can lead to higher returns. Mean-reversion is one model that may offer a way to adjust factor weights based on their performance, allowing for some tilting of the portfolio without fully equal-weighting or allowing any one factor to dominate the portfolio.