Risk isn’t a bad thing – when it’s intentionally, carefully added to a portfolio in an effort to boost returns. But hidden risks are what keep investors and financial advisors up at night. Over the past year, the Invesco Global Solutions team examined hundreds of financial advisor portfolios, and we discovered that a common source of hidden risk is unintended factor exposures that could impact the ability of the portfolios to achieve the outcomes they are looking for. Fortunately, there are ways to diagnose and address this problem.
What are factors?
Factors are measurable characteristics of a security that help explain its performance. Whether they know it or not, most investors already has exposure to factors – the key is understanding and managing that exposure in a way that aligns with an investor’s investment objectives.
What did our analysis reveal?
One way that we help advisors is through our Custom Portfolio Analysis (CPA) service. Recently, we compiled data from 121 CPAs performed in the second quarter of 2018, to assemble an up-to-date snapshot of portfolio construction insights.
Our analysis of equity factors uncovered that, on average, these portfolios had a structural underweight to the Value factor as well as significant biases to the Size and Momentum factors (Figure 1). Factor exposures are not mutually exclusive; however, a large tilt into any one factor may result in unwanted concentration risk that leaves portfolios vulnerable to changes in the market cycle.
Figure 1: On average, portfolios had an overweight to Size and Momentum, and an underweight to Value
1Exposure represents benchmark-relative factor volatility.
Source: Invesco Global Solutions CPA analysis from April 1, 2018, through June 30, 2018. Factors analyzed are standard based on the BarraOne Risk Model.
Why is this significant?
Figure 2 below shows that Value has exhibited negative correlation to Size and Momentum. Combining lesser-to-negatively correlated factors can help increase diversification, reduce concentration risk and volatility. Therefore, if a portfolio is overweight to Size and Momentum while underweight to Value, it may not be nearly as diversified as investors believe.
Figure 2: Value has had a negative correlation to size and momentum
Source: Invesco Global Solutions as of March 5, 2018. Equity market is represented by the Russell 3000 Total Return Index, based off data from Jan. 31, 1994, to July 31, 2017. Each factor is a subset of this index. Past performance does not guarantee comparable future results. An investment cannot be made directly into an index.
What does this mean for investors?
We believe these findings present a compelling opportunity in the current market environment. According to our research, Value has historically outperformed Size and Momentum during high volatility periods and in early contraction (Figure 3). This may be particularly useful given our capital market expectations over the next five years point to increasing volatility across most major asset classes.
Figure 3: Value has outperformed Size and Momentum in high volatility early contraction periods
Source: Invesco Global Solutions as of March 5, 2018. Equity market is represented by the Russell 3000 Total Return Index, based off data from Jan. 31, 1994, to July 31, 2017. Each factor is a subset of this index. Past performance does not guarantee comparable future results. An investment cannot be made directly into an index. Early contraction scenario represented is stress-tested and is calculated by applying historically observed shocks to current exposures.
Key takeaway: Diversify equity factor exposure with Value
For portfolios that are underweight Value, adding exposure to this factor could potentially increase diversification, reduce concentration risk and provide downside risk mitigation this late in the market cycle.