The rationale behind the factors is that from many years of academic research, it was discovered that by tilting portfolios with these factors, an above market return could be achieved. The success of the factor-tilting can also be replicated, over and over within a long period of time.
Equities
MARKET
Shares vs Bonds
We know that equities (shares) hold a premium return over bonds in the long term. Therefore clients who need a higher return need to hold more equities over the long term. I call this the see-saw effect. One end represents the client’s appetite for risk, the other side is the need for risk to provide a higher return. Those clients with low needs or expectations with their money may only require a relatively low return. Those with high expectations will require a higher return and a higher exposure to equities.
COMPANY SIZE
Small vs Large
Small companies will outperform large companies of the long term. It is very common for investment managers and clients to pick large well-known companies., There may be seen as safe but don’t hold the premium return that small companies do over the long term.
RELATIVE PRICE
Premium Growth
Value companies (companies that have a higher book to make value) hold a premium over growth companies.
PROFITABILITY
High vs Low Profit
Although it sounds obvious, high-profit companies outperform low-profit companies. Putting this factor together with say a small company factor would explain why some small companies outperform large companies.
Bonds
TERM
How Long?
A bonds return tends to peak at 5 years. After that point, the return flattens but the risk continues.
CREDIT
High vs Low Return
A bond with a poor credit rating will normally provide a higher return for the additional risk taken. We prefer to use that risk within equities where you are more likely to be adequately rewarded for the risk taken. Finance companies are a good example where this type of investment, although a little higher than bank rates, did not provide an adequate level of return to reward the risk taken.
