Time to read: 3 min
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, every investor 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
1 Exposure 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.
Blog header image: Invesco
The Russell 3000® Index is an unmanaged index considered representative of the US stock market. The Russell 3000 Index is a trademark/service mark of the Frank Russell Co. Russell® is a trademark of the Frank Russell Co.
A bull market is an environment in which stock prices are rising or are expected to rise. A bear market is an environment in which stock prices are falling and widespread pessimism causes the stock market’s downward spiral to be self-sustaining.
Factor investing is an investment strategy in which securities are chosen based on certain characteristics and attributes that may explain differences in returns. There can be no assurance that performance will be enhanced or risk will be reduced for funds that seek to provide exposure to certain quantitative investment characteristics (“factors”). Exposure to such investment factors may detract from performance in some market environments, perhaps for extended periods. Factor investing may underperform cap-weighted benchmarks and increase portfolio risk.
There is no guarantee that low-volatility stocks will provide low volatility. A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets. The momentum style of investing is subject to the risk that the securities may be more volatile than the market as a whole, or that the returns on securities that have previously exhibited price momentum are less than returns on other styles of investing. Investing in securities of small capitalization companies involves greater risk than customarily associated with investing in larger, more established companies.
There are risks involved with investing in ETFs, including possible loss of money. Index-based ETFs are not actively managed. Actively managed ETFs do not necessarily seek to replicate the performance of a specified index. Both index-based and actively managed ETFs are subject to risks similar to stocks, including those related to short selling and margin maintenance. Ordinary brokerage commissions apply. The Fund’s return may not match the return of the Index. The Fund is subject to certain other risks. Please see the current prospectus for more information regarding the risk associated with an investment in the Fund.
Not all products available through all firms.
Shares are not individually redeemable and owners of the Shares may acquire those Shares from the Funds and tender those shares for redemption to the Funds in Creation Unit aggregations only, typically consisting of 50,000, 75,000, 100,000 or 200,000 Shares.
Christopher Hamilton, CFA®, CAIA
Head of Portfolio Advisory
Invesco Global Investment Solutions
Christopher Hamilton is Head of Portfolio Advisory for Invesco Global Investment Solutions. In this role, Mr. Hamilton leads Advisory Solutions efforts in the wealth management intermediary marketplace, with a focus on providing multi-asset portfolio construction research and guidance to financial advisors and wealth management platforms. As part of the Invesco Global Solutions franchise, he works to deliver in-depth portfolio research, analytics tools and investment solutions to investors across North America.
Prior to assuming his current position, he was part of the Wealth Management Intermediary strategy team, focused on developing multi-faceted distribution strategies for key clients across multiple channels. Prior to joining Invesco, Mr. Hamilton was a portfolio manager for U.S. Trust, focused on building out asset allocation and portfolio construction frameworks, and leading manager selection efforts for high-net worth individuals and institutions. He was also director of business analysis for Phillips 66, where he engaged in merger, acquisition and divestiture efforts, as well as capital market activities for the organization.
Mr. Hamilton earned a BA degree in economics from the University of Illinois at Urbana-Champaign, and an MBA from Rice University. He holds the Series 7, 63 and 66 registrations. He also holds the Chartered Financial Analyst® (CFA) designation, the Chartered Alternative Investment Analyst (CAIA) designation, and is a member of the CFA Society of Houston.
Joshua Lee, CFA®
Vice President of Portfolio Advisory
Invesco Global Advisory Solutions
Joshua Lee is Vice President of Portfolio Advisory for Invesco Global Advisory Solutions. In this role, Mr. Lee is responsible for Advisory Solutions efforts in the US retail marketplace, with a focus on providing multi-asset portfolio construction research and guidance to financial advisors and home offices. As part of the Invesco Global Solutions franchise, he delivers in-depth portfolio research and analytics tools to investors across the country.
Prior to assuming his current position, he was part of the Invesco US Retail Sales Distribution team and served as an internal sales consultant, focused on providing guidance for Invesco strategies and services to financial advisors.
Mr. Lee earned a BA degree in economics from the University of Texas at Austin. He holds the Series 7, 63 and 65 registrations. He also holds the Chartered Financial Analyst® (CFA) designation and is a member of the CFA Society of Houston.