Part 1
What is Factor Investing?
Factor investing is an investment approach that targets quantifiable characteristics called "factors" which are systematic drivers of risk and return across and within asset classes. There are two main types:
- Macroeconomic factors, which capture broad risks that drive returns across asset classes (such as Equity, Interest Rates, and Credit)
- Style factors, which capture common risk drivers within asset classes, such as Fixed Income Carry, Momentum, or Quality.
Want to dive into a different way to think about factors? Read more about our "Bacon Factor" analogy.
Why Use Factors?
Traditional asset allocation can hide risk in portfolios because different asset classes may have exposure to the same risk factors. For example, high yield corporate bonds and stocks have exhibited a long-run positive correlation due to each having exposure to the Equity risk factor (i.e., long-term economic growth and profitability of companies). By viewing portfolio risk through the lens of unique and independent risk factors, institutional allocators can better understand what is driving risk and return, which may lead to a more truly diversified portfolio.
For example, an analysis done using Venn’s Factor Lens of the SPDR Bloomberg High Yield ETF indicated that only 13% of the fund’s risk was driven by our Credit factor, whereas an additional 33% of the risk was driven by our Equity factor.
You can even use factors to quantify the hype behind artificial intelligence, or to better understand the active bets of equity sectors, all in one common language of risk.
More factor FAQs can be found here.
What Are the Factors in the Two Sigma Factor Lens?
A factor lens represents a common language to understand the investment landscape and multi-asset institutional portfolios. It is often carefully constructed, but can vary meaningfully depending on different approaches or providers. For example, a factor lens could have hundreds of factors, designed for the tactical use of hedge fund managers, or perhaps just focus on a handful of the most impactful drivers of return, designed for asset owners. Some can be focused on macro factor investing, while others can be dedicated equity factor models.
Venn's Factor Lens uses a multi-factor approach consisting of 18 factors in four categories: Core Macro, Secondary Macro, Macro Styles, and Equity Styles. Investors can think about these 18 factors as a nutritional label for all investments, purposefully selected as the essential drivers of risk to help manage multi-asset institutional portfolios in a holistic way.
This includes a unique factor selection process that further filters down our 18 factors to those most relevant for a specific investment or portfolio. The simplicity and intuitive output of Venn's Factor Lens was designed with institutional asset owners in mind, though there are many cases where asset managers can also leverage it for value (for example, fund of fund managers or other asset managers looking to demonstrate the output of their strategies). Venn’s factor analysis is designed to be:
- Holistic: by capturing the large majority of cross-sectional and time-series risk for typical institutional portfolios.
- Parsimonious: by using as few factors as possible.
- Orthogonal: with each risk factor capturing a statistically uncorrelated risk across assets.
- Actionable: such that desired changes to factor exposure can be readily translated into asset allocation changes.
Macro Factors
Macro Factors correspond to the principal drivers of asset class returns. They are broadly known, widely accessible at a relatively low cost, and often can explain significant amounts of risk in diversified institutional portfolios.
Core Macro
- Equity: Exposure to the long-term economic growth and profitability of companies.
- Interest Rates: Exposure to the time value of money (interest rates and inflation risk).
- Credit: Exposure to corporate default and failure-to-pay risks specific to developed market corporate bonds.
- Commodities: Exposure to changes in prices for hard assets.
Secondary Macro
- Emerging Markets: Exposure to the sovereign and economic risks of emerging markets relative to developed markets.
- Foreign Currency: Exposure to moves in foreign currency values versus the portfolio’s local currency.
- Local Inflation: Exposure to inflation-linked rates relative to fixed nominal rates within the local currency area.
- Local Equity: Exposure to home bias (the tendency to invest in domestic over foreign equity).
Style Factors
These are lower-capacity risk factors shown to correspond to sizable common risk drivers across individual securities, but with lower correlations to asset class returns. Academic research has identified multiple style factors that appear to have long-term return premia resulting from investor behavioral biases or risks associated with the respective exposure. In short, style factors correspond to sizable common risk drivers within asset classes, such as individual stocks or bonds. Style factors are associated with systematic alpha over time and often accessed by institutional investors.
Macro Styles
- Equity Short Volatility: Negative exposure to moves in equity market volatility.
- Fixed Income Carry: Exposure to high-yielding 10-year bond futures funded by low-yielding 10-year bond futures.
- Foreign Exchange Carry: Exposure to high-yielding G10 currencies funded by low-yielding G10 currencies.
- Trend Following: Long-short exposure to multi-asset-class futures based on 6- to 12-month trailing returns.
Equity Styles
- Low Risk: Long exposure to stocks with low market betas and residual volatility and short exposure to higher-risk stocks.
- Momentum: Long exposure to stocks that have outperformed recently and short exposure to recently underperforming stocks.
- Quality: Long exposure to stocks with low leverage and high profitability and short exposure to lower-quality stocks.
- Value: Long exposure to stocks with low prices relative to accounting fundamentals and short exposure to higher-priced stocks relative to fundamentals.
- Small Cap: Long exposure to stocks with smaller market caps and short exposure to larger-cap stocks.
- Crowding: Short exposure to U.S. stocks that are widely shorted by the investment community and long exposure to those stocks that are not as widely held short.
Read our most recent factor performance report here.
Residual
Residual represents idiosyncratic sources of risk (i.e., uncorrelated to other known factors). It is essentially the risk not captured by any factors in a factor model, and can be interpreted as the risk and return driven by unique manager skill, from unaccounted factors, or model noise. Institutional allocators often seek a high amount of residual risk that results in positive return, indicating a truly differentiated exposure. However, not all managers have residual risk that captures a positive return. Investors should be careful when interpreting the sources behind residual risk and return when looking at historical performance.
Learn more about residual in our piece "Quantifying the Magnificence of the Magnificent 7”.
Factors and Risk Premium
Factors with strong empirical evidence and/or fundamental justification for a long-term return premium are considered to have a “risk premium,” which may reward investors for holding exposure to that risk factor over time. However, not all identifiable risk factors carry a corresponding risk premium.
A risk premium may compensate investors for bearing certain risks such as undiversifiable market risk, mandate constraints, operational complexity, or behavioral biases like risk/loss aversion, herding mentality, or recency bias.
The Equity factor, which represents exposure to fundamental risks such as macroeconomic growth and corporate profitability, is an example of a macro factor that has historically delivered a positive long-term return in excess of the risk-free rate.
The Momentum factor, not to be confused with Trend Following, is often thought to be driven by investor behavioral biases such as initial under-reaction to fundamental news about companies. This is an example of a style factor that has historically delivered a positive long-term return.
Factor Analysis to Review Portfolio Risk
A common Venn use case is reviewing a manager’s factor analysis output to better understand their style and approach, and how it may contribute to total portfolio risk.
Sometimes the output can help confirm one’s understanding of what the manager is doing, and other times it can lead to questions for the manager about portfolio management and potential exposure.
An example may be a manager that claims to invest in stocks based on value characteristics, but factor analysis output indicates a zero or negative Value factor exposure. This would be unexpected based on the mandate, so an investor might want to better understand what’s driving that result.
It's true that risk transparency into individual manager portfolios is powerful, but when multiple managers and different assets are combined, it is ultimately the total portfolio exposure that will drive investment outcomes. The recently popularized "Total Portfolio Approach" means evaluating every asset and manager through a common factor lens, not asset class silos, so that risk and return are understood in the context of the whole portfolio. This is the core of what Venn is built to do. For example, one can quantify how individual managers, across asset classes like equities, bonds, real estate or commodities, are contributing to a total portfolio's Interest Rates factor exposure. Ultimately, a factor lens is the essential engine for taking a Total Portfolio Approach.
Request a demo to learn more about how our clients use Venn's Factor Lens for manager evaluation or to implement a Total Portfolio Approach.
Using Factors for Stress Testing
Factors can also help in conducting hypothetical stress testing. For example, an institution might decompose their portfolio into its factor exposures today and then see how it might have performed if it existed in 2008. They might also translate well-known market indexes into factors, such as the S&P 500 index or Bloomberg US Aggregate, to see how their portfolio might respond to a meaningful increase or decrease in these exposures. They might even stress test the probability of funding failure for a private asset sleeve alongside a liquidity sleeve.
Additionally, understanding current factor exposures and historical factor returns opens up the opportunity to forecast portfolio metrics like return, volatility, tracking error, and more. Customizing these forecasts by changing exposure or return windows, or even starting from a place of capital market assumptions, can provide institutional investors with important context for future possibilities.
Returns vs. Holdings Analysis
Venn offers returns-based analysis that helps our clients measure exposure to factors that cut across asset classes even when they do not have access to holdings level information in their portfolio. Returns-based analysis requires only a time series of manager or portfolio returns and the time series factor returns provided by Venn. This is designed to aid in the analysis of institutional investor portfolios whose investments span multiple asset classes, and where holdings data is more sparse. With that being said, holdings information can provide valuable context for returns-based analysis.
Venn and Factors
Venn leverages research and expertise in data science to help institutional investors better understand the risk composition of their portfolios and investments.
By using our regression based approach, Venn can help allocators learn more about the potential factor exposure of their portfolios (absolute or relative to benchmark) based on the return histories of their current portfolio holdings with minimum barriers to entry.
Venn displays the estimated exposures and contribution to risk and return for each factor identified in any return stream. Venn can also assist in allocation decisions by analyzing and estimating the historical marginal impact of adding, eliminating or reweighting an investment in your portfolio. This includes reporting solutions, and features to view private assets through a public lens, allowing for holistic analysis of a portfolio that includes not only multiple asset classes, but also private and public investments. Some of these features are part of Venn’s Private Asset Lab.
Our clients use Venn factor analysis to help them quickly answer critical investment and portfolio questions including:
- Which managers are providing differentiated exposure?
- What is a portfolio’s sensitivity to macro and style factors?
- How might a portfolio react to certain market shocks or past events?
- Are individual investments and portfolios delivering the intended benefit?
- What do future capital markets expectations mean for the portfolio?
- How can a proposed change impact portfolio outcomes?
Watch this video to learn about Venn's Factor Lens:
