How to get the best out of smart beta (factor-based) investing

Jason Swartz, head of portfolio solutions at Satrix.

The challenge today is no longer about how to blend active and passive, but how to blend the underlying risk factors (or styles such as value, quality, dividend yield and momentum) to build more diversified, risk-smart portfolios. Factors are considered to be the fundamental building blocks of investment returns. Understanding the different risk factors in your portfolio will lead to better insights and more informed portfolio construction decisions, says Jason Swartz head of portfolio solutions at Satrix. As a result, what is now termed ‘factor investing’ is beginning to revolutionise the investment industry.

Factor-based strategies (or smart beta) exploit the returns that come from harvesting factor ‘premiums’. Targeting these premiums can improve the risk-return profile of a retirement fund portfolio. But exactly how to choose the right factor strategy or combination, and how to harvest the inherent risk premia can be a challenge for trustees and other allocators of capital.

In this article, our intent is to show how blending style factors (ie, making strategic allocations to factors that are not correlated) can help diversify portfolios, mitigate risk and enable your portfolio to generate a return premium above that of the broad market.

“Blending single-factor portfolios has great value for investors who appreciate diversification among factors, as well as the transparency and predictability of performance between the factor building blocks”, says Swartz. These blended factor portfolios tend also to deliver higher risk-adjusted returns than the broad equity benchmarks, with a lower tracking error than most single-factor strategies.

Although many single-factor strategies have earned a premium above the market, each of these factors have also suffered periods of underperformance under certain market conditions, because of their innate cyclicality. As such, the risk of being exposed to a single factor is significant and often not diversifiable. For this reason, blending a number of uncorrelated factors produces more diversified portfolios. This blended portfolio mitigates the peculiarities associated with each individual factor, and produces return outcomes that are substantially more reliable and predictable.

Figure 1: 3 year distribution of returns for Value versus a blend of Value, Quality and Momentum

Can you tactically adjust your factor allocations?

One contentious position on blending factors is: do you dynamically or tactically adjust your factor allocations to take advantage of cyclical performance, or do you employ static (fixed) allocations through time and rebalance periodically?

At Satrix, we have taken the latter view, arguing that timing factor performance is enormously challenging, and that the incremental impact of simply using static allocations will pay off over time. We do not discourage clients from employing factor timing – at the margin – based on either valuations or economic cycles. However employing this approach would require a specific skills set and expertise. In our view, strategic allocations to specific factors better serves the requirements of a blended factor portfolio best.

When blending single factors, consideration needs to be given to which factors are included in the blend. In Table 1 below, we illustrate our house-view equity blend of domestic factors which utilises an equal-weighted approach, and is made up of our four single factor building block portfolios.

Figure 2: Factor allocations to Satrix Smartcore (equity factor blend product)

Blending single-factor portfolios has great value for investors who are looking to maximise diversification amongst factors, and who appreciate the transparency and predictability of performance between the factor building blocks.

These blended factor portfolios tend also to deliver higher risk-adjusted returns than the broad equity benchmarks, with a lower tracking error than most single-factor strategies. Contact us to discuss how we can customise a blended portfolio for your members to optimise the risk return profile of your members.

Satrix Managers (RF) (Pty) Ltd (Satrix) is a registered and approved Manager in Collective Investment Schemes in Securities and an authorised financial services provider in terms of the FAIS. Collective investment schemes are generally medium- to long-term investments.