Given the drawbacks with passive investments that track indices based solely on market capitalisation, factor investing is attracting greater interest, particularly in markets such as Australia where exposure to the index creates concentration risks within a portfolio. The attraction of factor based investing is the research-driven principle that there are proven drivers of positive, risk-adjusted returns such as:

• quality (financially healthy firms outperform)
• value (inexpensive stocks outperform)
• size (smaller companies earn greater returns)
• momentum (good recent performance continues).

The relative performance (versus the broader market) from exposure to a single factor tilt can, however, vary from one year to the next, depending on the investment environment, with the magnitude of underperformance potentially significant and for extended periods. So it’s critical that investors understand how these factors behave across different market environments. However, they must also accept that it is very difficult to tactically time when to use the different tilts. This is no different to more traditional, active equity management.

For single-factor tilts, it is also important to consider the risk of portfolios being skewed to a limited number of industries or sectors in the absence of defined concentration limits, and if investors are looking to add a factor tilt to an existing portfolio, that the latter may already exhibit a strong factor bias.

Finally, for investors wanting to actively manage the allocation between factor tilts, careful consideration needs to be given to transaction costs because of bid-ask spreads and the impact of taxes, as these can materially impact real-world returns.

If you would like more information please call 1300 ELSTON or email info@elston.com.au and an adviser will be in touch.