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3 Things You Should Know About Factor Investing

Factors are broad, persistent drivers of returns that have been proven to add value to portfolios over decades, according to research data from Dartmouth College . Factor strategies like smart beta capitalize on today’s advancements in data and technology to give all investors access to time-tested investment ideas, once only accessible to large institutions. As factor strategies continue to gather attention, some misconceptions have arisen. I am highlighting – and clearing up – a few here today. 1. Factor strategies are stocks-only. False. Equity smart beta strategies like momentum, value, quality and minimum volatility are by far the most adopted factor strategies and often serve as the gateway to this type of investing. But it’s important to note that the concept extends beyond equities to other asset classes, such as bonds, commodities and currencies. As an example, fixed-income factors are less well known, but similarly aim to capitalize on market inefficiencies. Bond markets are largely driven by exposures to two macroeconomic risk factors: interest rate risk and credit risk. One way that bond factor strategies try to improve returns is by balancing those risks. As investors look for more precise and sophisticated ways to meet their investment goals, we believe we will see more factor strategies in other asset classes, as well as in long/short and multi-asset formats. 2. Factor investing is unnecessary, because my portfolio of stocks, bonds, commodities, hedge funds and real estate is well diversified. Maybe, maybe not. Oftentimes, a portfolio is not as diversified as you might think. You may hold many different types of securities, sure, but those securities can be affected by the same risks. For example, growth risk figures prominently in public and private equities, high yield debt, some hedge funds and real estate. So, as economic growth slows, a portfolio overly exposed to that particular factor will see its overall portfolio return lowering as a result, regardless of how diverse its holdings are across assets or regions. Factor analysis can help investors look through asset class labels and understand underlying risk drivers. That way, you can truly diversify in seeking to improve the consistency of returns over time. 3. Factor investing is a passive investment strategy. Not really. At least we don’t look at it that way. Factor investing combines characteristics of both passive and active investing, and allows investors to retain many benefits of passive strategies, while seeking improved returns or reduced risk. So to us, factor investing is both passive and active. While we think traditional passive, traditional active and factor strategies all have a place in a portfolio, it is not news that some of what active managers have delivered in the past can be found through lower-cost smart beta strategies. This post originally appeared on the BlackRock Blog.

How I Learned To Stop Worrying And Love The Bond

Source: beralinka / Shutterstock U.S. Treasuries are not cheap. At roughly 2%, nominal yields are less than a third of the 60-year average of 6%, according to Bloomberg data. Although they are not as egregiously expensive as 10-year Swiss government bonds-currently trading at a yield of negative 0.25%-U.S. bonds are offering a relatively paltry real return, even after adjusting for low inflation. Moreover, government bonds are potentially more volatile. For now, that volatility is being suppressed by the lethargic pace of the Federal Reserve’s (Fed’s) tightening cycle. But there is plenty of risk embedded in traditionally safe government bonds. Low coupon rates mean that investors get almost all of their cash flow at maturity. This pushes up a bond’s duration or rate sensitivity. In practice, a 10-year bond yielding 2% is more rate sensitive than a 10-year bond yielding 6%. If rates start to rise, bond volatility will be exacerbated by higher durations. Another way of looking at this: With a 2% coupon, a relatively small rate move will wipe out a year’s worth of interest. But despite high prices and the potential for more volatility, there is still a very good reason to continue to own government bonds: diversification. Use bonds as a hedge While government bonds currently produce little in the way of income, U.S. Treasuries have been providing a hedge against equity risk. Since the financial crisis, but really since the bursting of the tech bubble, bonds have been more likely to move in the opposite direction to stocks. This trend has only intensified since the financial crisis. Why should this be the case and is it likely to continue? Looking back over the past 25 years, a period of low and stable inflation, stock/bond correlation has generally moved in tandem with monetary policy, as measured by the effective federal funds rate. In the 1990s, when investors were more worried about inflation and an aggressive Fed, the correlation between stocks and bonds tended to be positive. However, as the Fed has increasingly pushed the boundary of monetary accommodation correlations have fallen. What history tells us Over the past quarter century the level of the fed funds rate has explained nearly 50% of the variation in stock/bond correlations, according to Bloomberg data. Take a look at the chart below. During this period, when the policy rate was above 2%, the average correlation was close to zero. In periods when the fed funds rate has been below 2%, as has been the case since late ’08, the average correlation has been roughly -0.25. (A correlation of 1 means two asset classes move in lockstep. A negative correlation means they move in opposite directions. A zero correlation means their movements are unrelated.) As long as the Fed remains reluctant to raise rates, history would suggest that the correlation between stocks and bonds is likely to remain negative. Click to enlarge A negative stock/bond correlation is important for managing portfolio volatility. Portfolio risk is not simply the sum of the volatility of the individual assets; it is also influenced by the correlation between those assets. To the extent that longer-term government bonds provide diversification-a scenario more likely in an environment in which the policy rate is low-bonds have a role to play in a portfolio, even if they are expensive and more volatile. Russ Koesterich , CFA, is Head of Asset Allocation for BlackRock’s Global Allocation Fund and is a regular contributor to The Blog . ‘This post originally appeared on the BlackRock Blog’.

Loans, Write-Downs And Shares…Oh My!

My family and I recently went to see the musical Wicked . Having already been with my wife when it first opened in 2003, I was thrilled to relive the awesome and spine-tingling performance with my kids. The creative genius of Wicked is its backstory – the plot that no one hears throughout the Wonderful Wizard of Oz . Turns out, the wizard isn’t really all that wonderful, and the witch isn’t so wicked after all. This got me thinking about parallels to the world of finance and how things aren’t always as they seem. We all know that the S&P/TSX Composite Index is heavily skewed toward the financials (37%), energy (20%) and materials (12%) sectors, but attitudes towards these industries have become rather split lately. In the past few years, financials have been all aglow thanks to consistently improving quarterly results, whereas the resource sectors have been a source of pain amid lower earnings, dividend cuts and write-downs. While faith in the financial sector may be justified, investors might not realize just how dependent the Canadian stock market has become on its earnings and dividends. According to data compiled by Bloomberg, while financials make up more than a third of the market cap, the sector accounts for more than 50% of the earnings and slightly less than half of the dividends paid on the S&P/TSX Composite Index. Click to enlarge Something wicked this way comes? Outsized dependencies are rarely a good thing in investment portfolios. For example, in the late 1990’s investors became overly dependent on technology companies trading at ever higher multiples, and then found themselves in a post-financial-crisis love affair with emerging markets. In both of these cases, investors paid too little attention to the backstory: technology had become more than a third of the S&P 500 and paid no earnings, and emerging markets had become reliant on leverage and an ever-expanding China. Investors also became overly dependent on U.S. financials a decade ago when the sector contributed more than 50% of the S&P 500’s earnings and dividends in 2006 only to fall off a cliff when the financial crisis hit two years later. The financial sector also grew to almost a quarter of the listed market in 2006, well above today’s level of 17% (still high but just not as high). Does this mean Canadian financials are due for some sort of rude awakening? Not necessarily. It depends on whether Canadian banks will report more bad loans and will have to incur larger write-downs than are currently reflected in loan loss provisioning or the share price. Intuitively, the nearly 70% decline in oil prices over the past two years and the broadening difficulties in the Canadian energy patch would imply a greater risk of loan defaults. Moreover, banks could see declining revenue growth and weaker revenues as the indirect consequences of low oil prices work through the extensive supply chain. But for now, these worries are the backstory. Canadian share prices are following the lead story: The banks’ exposures are manageable, the banks are prepared, and they continue to stress-test their loan book. Importantly, investors should know what their exposures are. Right now, investors in Canadian stocks are highly dependent on earnings and dividends from the big banks. If Canadian financials were to dip, investors could be in for a rude awakening. With any luck, the energy and materials stocks won’t seem as wicked if the rise in commodity prices in recent weeks supports upward earnings revisions in the next few quarters. The best outcome for reducing dependency on the financials is growing earnings from other sectors, not falling earnings from the banks. What can Canadian investors do to help reduce dependencies and limit outsized domestic exposures to the financial, energy and materials sectors? I would recommend considering allocations to two sectors that are underrepresented in the Canadian equity markets, such as global healthcare and technology, where there has been better dividend growth and stronger secular growth trends. Source: Bloomberg. This post originally appeared on the BlackRock Blog