FolioBeyond Factor-Based Investing and Factor-Momentum Based Model

Strategy Summary

For the Equity markets broadly, FolioBeyond’s investment philosophy is derived from the fact that it is very difficult for investors to “beat” the market over time. This is due to a number of issues, specifically high investment management and fund fees, market timing efforts of investors, investors’ failure to regularly rebalance their portfolios, general lack of investor discipline to stay the course and stay invested, and tax-inefficient products and strategies. Consequently, a well-diversified portfolio along with modified investor behavior that addresses these pitfalls will not only limit risk but provide the potential for investment success.

To deliver on this philosophy, FolioBeyond creates globally diversified portfolios tilted towards Style Factors (Value, Small Size, Low Volatility, and Price Momentum) which have proven to reward investors with higher returns over time. Our portfolio construction and management exhibit discipline in fund selection, portfolio rebalancing and focusing on what is controllable in order to eliminate the behavioral tendencies that can hurt investment portfolio performance. FolioBeyond’s strategy also entails protecting investors from short-term and, at times, faulty thinking and behavior about risk and return.

Diversification geographically and across Factors is also a fundamental investment principle. This facilitates management of risk, reduction of volatility, rotation in the portfolio, smoothing of returns over time, capturing global returns and, ultimately, meeting long-term financial goals. The use of Factors points to the enhancement of returns over full market cycles. Academic research has identified these primary Factors which are robust – Value, Small Size Capitalization, Low-volatility and Price Momentum. These factors are well documented in markets around the world and across different time periods.

Blending Factor-based Indices has produced better results with similar or lower volatility than the broad market. An equally-weighted aggregate of domestic Factor-based indices has outperformed the S&P 500 Index by a multiple of ~1.5X with less volatility for the 24 years ending in 06/19.

Model Summary

A consistent theme in equity markets is momentum - that which does well continues to do well, for some time to come, and vice-versa. Much recent research has shown that this persistence extends to the factors that drive equity performance. For example, in a recent paper (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3014521), Ehsani and Linnainmaa show that “the average factor earns a monthly return of 2 basis points following a year of losses and 52 basis points following a positive year.” Rabener showed (https://www.factorresearch.com/research-sector-versus-country-momentum ) that “the performance of both long-short portfolios was positive, indicating that simple performance chasing with frequent rebalancing was an effective strategy”, that “the performance of Momentum on country level is higher” and that “the cross-sector and country Momentum portfolio generated the highest absolute and risk-adjusted returns.”

The net result of this concept is that we can apply the methodology of systematic “performance chasing” to individual ETFs. We can further enhance the effectiveness of “performance momentum” by choosing those ETFs very carefully so that they are as “pure” as possible, i.e., they represent one (or a few) factors as cleanly as possible. A carefully chosen portfolio of ETFs representing individual factors, weighted by their performance, is therefore very likely to produce consistent outperformance. It is additionally unlikely to suffer excess return degradation over time because as a factor starts to decline in its outperformance, its weighting in the portfolio will automatically decline.

Our models systematically find the best-performing factors, as represented by ETFs. We then use a proprietary weighting function to give the highest performing factors the highest weights in the portfolio, and the lowest-performing factors the lowest weights, while carefully balancing concentration risk, liquidity risk, execution risk, and taxes, in relation to overall performance and rebalancing frequency.