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When it comes to investing, how much of a factor are factors?

Factors are the underlying drivers that influence and explain the way an investment acts. Some portfolios exhibit a high correlation with a targeted factor's behavior. The goal is to give investors exposure to a desired factor efficiently.

For example, one factor could be price-to-book. A value factor portfolio would likely favour low price-to-book ratio stocks, relative to the broad market, in its construction methodology.

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Factor-based investing is becoming a bigger part of the product universe. It's worth understanding how quant managers and index providers achieve factor exposure.

As we build factor-driven portfolios at Vanguard, we have to ask what makes a portfolio sensitive to a particular factor. Three main choices affect this sensitivity: stock selection, stock weighting and implementation.

It starts with stock selection

A portfolio will have high sensitivity to a particular factor if the stocks within it have similar attributes to the ones used to define the factor. Which characteristics should be used to target a given factor in a portfolio?

There is debate in the asset management and index industries.For more established factors, like value, most of the industry has converged toward one characteristic or a combination, e.g. price-to-book, price-to-earnings, price-to-cash-flows, and price-to-sales. There’s not as much agreement around less-established factors, such as quality or liquidity.

Another question is how many characteristics managers or index providers should use to adequately capture factor exposure. Three seems to be the magic number.

There are advantages and disadvantages. Using multiple characteristics does yield more robust portfolios, which reduces individual variable noise, data mining concerns, and potential crowding effects. However, combining too many variables leads to higher complexity, increasing portfolio-monitoring costs and due diligence efforts.

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At Vanguard, we believe that using three broad, underlying characteristics to construct individual factor products strikes the right balance between robustness and complexity. In the case of factors whose measure may be more multifaceted, we may use more than three characteristics. That will capture the many aspects of a company’s quality.

Overall, we choose variables that are well documented in the empirical literature, and that exhibit different behaviours across the business cycle.

Adjusting stock weighting

Selecting stocks with similar attributes is not enough to have high sensitivity to a particular factor. Another important choice is the methodology used to weight stocks within a portfolio.

Given a set of characteristics, a portfolio that gives higher weight to the securities with the strongest factor attributes is likely to have higher factor sensitivity. Here’s what we do with our single-factor products:

  • Rank each stock within the universe across each of the underlying characteristics for a given factor.
  • Compile an equally weighted “composite ranking” for each stock.
  • Convert that ranking into a factor score. 
  • Construct our portfolio by including the highest-scored stocks. We do that until we reach one-third of the market capitalization of the starting universe, by weighting each included stock according to its factor score.

Factor premiums exist across the entire market-cap spectrum. So we split the starting universe into three groups of stocks that cover the large, mid, and small part of the market. We score and rank stocks within each of their market-cap groupings, then give equal weight to each size group.

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This process enhances diversification, yielding hundreds of stocks in each factor strategy. That can greatly reduce concentration risk. Indeed, one way to build a high-exposure portfolio is to invest everything into a handful of stocks with the strongest factor attributes. However, not many investors would feel comfortable holding such a concentrated portfolio.

Another advantage is the greater emphasis on small- and medium-cap stocks. Historically, they’ve delivered much larger premiums across all factors. This aspect of our methodology helps reduce potential concerns about crowding within the large-cap segment of the market.

Our construction methodology also allows us to maintain a similar size tilt across all of our factor strategies, with an emphasis on small- and medium-cap securities. For investors, one possible way to reduce the effect of this size bias is to combine our factor funds with a large-cap index portfolio.

More complex approaches might yield similar or higher factor exposures than our methodology. But more complexity typically means less transparency.

One benefit of a relatively simple and effective weighting methodology is consistency across all factor funds. Many factor-fund managers or index providers use different portfolio construction rules and index guidelines for different factor products. We prefer a more holistic approach.

Implementation: maintaining factor exposure

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Selecting and weighting stocks based on the strength of their factor attributes is an important strategy. But it’s not enough to deliver a consistently high factor exposure. That’s because stock characteristics can evolve.

Some tend to exhibit substantial changes daily, such as past performance (momentum) and price-to-fundamentals (value). If you don’t rebalance the portfolio to incorporate these changes, the targeted factor exposure can decline significantly over time.

An active implementation is the best way to deliver a consistently strong factor exposure. At Vanguard we actively manage the portfolio, rather than relying on an index provider. That means we can score the stocks in the universe on a daily basis and rebalance our portfolio as necessary, rather than on a fixed schedule.

Active implementation allows us to adjust factor exposure more dynamically, and experience less factor decay than with an index-based option. It also helps us reduce costs by lowering index licensing fees, and gives us more portfolio management flexibility. The result is lower trading costs.

In evaluating competing factor-based strategies, investors need to understand the three variables that make a portfolio sensitive to a particular factor: stock selection, stock weighting and implementation.

Understand that, and you can better determine whether factor-exposure tilts are appropriate to help achieve long-term investment goals.


This content was produced by Vanguard. The Globe and Mail was not involved in its creation.

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