A portfolio which takes advantage of factor premia has been shown to offer the opportunity to outperform the market-capitalization index over the medium to long term. However, by maximising exposure to a desired factor and minimising incidental factors, this return can be far better targeted towards the intended drivers of risk and return.
The five key factors, which are often employed within an effective multi factor equity portfolio are: value, quality, momentum, volatility and size. We are able to use both technical and fundamental analysis to break down these factors. In examining these sub components we can identify which equities best define each factor. By having a high, medium or possibly low exposure to each of these factors we can customise the optimal portfolio to achieve investor's investment objectives and constraints.
However, there are a number of elements which need to be addressed in order to ensure these exposures are correctly correlated through asset selection. These include:
- Factor methodology and the advantageous use of proprietary factor definitions,
- Ensuring that factors remain statistically independent to avoid correlation contamination,
- Avoiding high stock specific risk, by focusing on portfolio construction and constraining areas, for example Sectors or countries, which are not explained by the strategies stock level insights.