Factor Allocation

Building good portfolios for clients is a critical task for advisors.  Creating an artful mix of stocks, bonds, and alternatives can make a big difference for returns and for client comfort.  James Picerno, writing in Financial Advisor, discusses how new factor indexes have the potential to change traditional asset allocation.  Speaking about the availability of many new factor indexes in ETF form, he writes:

The broader message is that indexing is moving past the standard beta carve-ups, such as small- vs. large-cap equities and value vs. growth stocks. A new era of factor-based indexing is dawning, and it promises to be far more nuanced and complicated.

Adding factor allocation to the traditional asset allocation framework certainly widens the possibilities for adding value. More risk factors equates with a richer opportunity set for exploiting the rebalancing process.

A study last year in The Journal of Portfolio Management lists more than a dozen factors, including volatility, momentum, earnings yield, currency sensitivity and interest-rate sensitivity. Several exhibit persistence and generate risk premiums, advises “On the Persistence of Style Returns” (by Stan Beckers of BlackRock and Jolly Ann Thomas at UBS). “More interestingly,” they report, “an active style overlay could have added significant value to the market index.”

Mr. Picerno quotes one especially enthusiastic observer.

“It’s a quantum leap in terms of engineering the portfolio,” says Harindra de Silva, president of Analytic Investors, a quantitative money manager in Los Angeles. “I think you’ll move from asset allocation to factor allocation.”

I don’t know if Mr. de Silva’s forecast will come to pass, but it’s clear that traditional asset allocation is changing.  I think advisors will adopt factor allocation if it allows them to productively fine tune their client’s exposures.  If it turns out that there is no practical advantage to factor allocation then it might not catch on.  More experience with some exotic factor indexes may be needed to learn how to use them most effectively.

In the meantime, there’s already evidence of a good way to improve your core equity exposure by combining relative strength with value.  This isn’t the first time we’ve written on this topic, but I think it is not being widely implemented.  Relative strength is a trend continuation factor and value tends to be a trend reversal factor.  Combining the two works extremely well because the excess returns from the two strategies are uncorrelated.

Correlations between assets can vary greatly, but correlations between strategies that are dynamic opposites are much more stable.  Replacing growth-oriented equities with high relative strength stocks to match off against your value exposure is something that you can do to improve your core equity allocation today.

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