Factor-Based Investing

TLDR: In this paper, the authors explore how investors should take account of underlying factors driving their portfolio returns and propose a pragmatic and intuitive approach for identifying and measuring underlying factors in a portfolio via a heat map.

Abstract: The asset management industry has seen a strong development of factor-based investing. The central idea is that each asset can be seen as a bundle of underlying factor sensitivities. A factor-based investing approach provides better insight into the risk decomposition of the investment portfolio’s assets and potentially leads to better investment decision-making. In this paper we explore how investors should take account of underlying factors driving their portfolio returns. We show that underlying factors explain the majority of return variation among assets. We find there are times that a given factor sensitivity offers exceptionally high or low rewards in all assets exposed to it. These circumstances lead to an opportunity for market timing. We propose a pragmatic and intuitive approach for identifying and measuring underlying factors in a portfolio via a heat map. We argue that investors seeking to adopt a factor-based approach use it in conjunction with traditional asset allocation, rather than as a substitute. In addition, we provide suggestions on how to embed the factor-based approach within an existing investment process. Finally, a word about our relationship with ABN AMRO. The research project on factor-based investing is part of ABN AMRO Private Banking’s continuous process to challenge, and thereby to improve the investment process with new insights in the financial markets and investment approaches. Therefore we were given the task of writing this report.