Adding equity factor exposure to a multi-asset portfolio

Part 5/10: Adding equity factor exposure to a multi-asset portfolio

Client level of adoption/allocation:

Multi-asset products have seen a significant upswing in popularity over the prior decade, and thus have become more mainstream in the asset management industry, both domestically and globally. Along with their increasing acceptance, multi-asset investing has seen substantial innovation in portfolio construction, including the inclusion of passive/index building blocks, being more solution orientated, as well as replacing the traditional asset allocation with ‘exposure allocation’.

All of these advances have assisted in making investment decisions that have a stronger emphasis on building more reliable and predictable investment outcomes. A further practical innovation is substituting the equity component of the multi-asset fund with a blend of factor exposures.

Jason Swartz, the head of Portfolio Solutions at Satrix, observes that often this substitution has a significantly positive impact on the overall fund peformance from a risk and a return perspective. In his sample set the risk adjusted return of the portfolio improved from 1.6 with traditional equity allocation to 1.74 after the substitution with a blend of factor exposures, as measured over 15 years.

This is indicative that the equity factor blend embodies strong diversification characteristics through lower correlations to other asset classes. This is particularly beneficial to the fund during periods of market stress, where the equity component ultimately determines the fund’s drawdown. Typically, a factor-blend equity component can be constructed to consist of more defensive characteristics than index or active managers, by virtue of blending uncorrelated factors together in an optimal way.

In our view, using factor building blocks is a natural extension of passive multi-asset solutions, given the tailwind of financial innovation and product development in this space. A key principle of how we build multi-asset portfolios that aligns with our view on building equity factor portfolios, is applying strategic allocations to asset class weights, as we do with factors allocations. Our view is supported by a host of academic and practitioner research that says strategic asset allocation is the most important decision to performance, contributing to anywhere from 80% to 95% of portfolio returns. Added to this, numerous supporting empirical studies have found only a minority of managers possess significant asset allocation / market timing skills.

For more information on this topic, please feel free to contact us directly or visit our website.