How to Use Factor Funds in a Diversified Portfolio

Active management has been out of favor for a while–high fees, high tax burdens, and poor long-term performance. But with the slow rise of actively managed ETFs, which have lower costs and more tax efficient than traditional active mutual funds, the gateway to active management has potentially been reopened.  This is certainly a positive move, but cheaper more tax-efficient active funds don’t answer the question of how should one use active exposures in a portfolio. We address this question in this post and propose several reasonable approaches one can take to incorporate active factor funds or ETFs into a diversified portfolio:

1. Core-Satellite: The core of the portfolio is cheap index funds, the satellite funds are concentrated active ETFs.
2. High-conviction: The core is active ETFs, combined with strategies and asset classes that tend to work well at different times.

Let’s dig into each of the approaches in more detail. But first – let’s talk about what a factor fund actually is. A factor fund is an actively managed mutual fund or ETF with a bias towards some particular driver such as momentum, quality, liquidity, etc.

Core-Satellite Approach

The Core-Satellite approach is fairly simple — for the “core” of the portfolio (let’s say 80%), invest in passive index funds. For the “satellite” of the portfolio (the other 20%), invest in highly active factor ETFs. Additional information can be found from the CFA Institute and Vanguard.

Why would this be good for an advisor or a DIY investor?

One issue with going “all-in” on actively managed factor funds is that they tend to have a large deviations around an index (i.e., tracking error). For advisors who have to answer to short-horizon clients that review their accounts daily (or DIY investors who always compare themselves to an index), tracking error can create angry clients very quickly.

The core-satellite approach may be optimal in this situation, because, by construction, a large part of the portfolio is allocated to passive index funds, which always keep the portfolio roughly inline with broad benchmarks. This core-satellite approach will lower tracking error of the overall portfolio, but give clients a shot at outperformance over time.

How much is dedicated to passive and how much is dedicated to active really depends on the client-advisor relationship and the amount of time the advisor spends educating clients on thinking long-term when it comes to portfolio performance. The details of creating an effective core-satellite approach can get complex, but we outline some basic principles of concepts related to a core-satellite approach here.

High-Conviction

The high-conviction approach is the approach we take with our personal wealth and most of our clients. Why we take this approach is described in our blog about the robust asset allocation index and in DIY Financial Advisor.

In this approach, the passive part of the portfolio does not exist because it is effectively captured in a long-only diversified portfolio already. There are many active strategies available, but we believe that Value and Momentum are the best long-term bets when it comes to active management.

Of course, the problem with high-conviction active portfolios is they aren’t the entire market, and can gyrate wildly around an index. If an advisor has short-term focused investors and the gyration is positive, you’re a hero, but if short-run performance is negative, you no longer have a career in asset management-yikes!

We recommend that advisors building a high-conviction active portfolio combine a variety of top-shelf concepts so they help diversify their client’s exposures and also so they limit their own career risk (unless this isn’t a factor because of unique clients).

Sounds great, but if high conviction has a higher expected risk-adjusted return, why diworsify?

Consider high conviction value investing, which sounds so simple — buy the cheapest highest quality stocks you can find. The problem with these strategies is they can underperform for long stretches of time! After 6 years of underperformance, are you really going to stick with the strategy? For most advisors (and their clients) and DIY investors, the answer would be NO! 

So diversifying across high-conviction active ideas is critical! Ideally, we could find strategies that work well at different times, and then just allocate a portion to each of the strategies. For example, as shown in our blogs about how to combined value and momentum, part one and part two, Value and Momentum tend to work well at different times. So one might consider investing in both value and momentum, as opposed to focusing on the absolute merit of one over the other.

Conclusions on factor funds

Overall, we outline two reasonable approaches to using high conviction factor funds: Core-satellite and high-conviction. For those advisors and investors who want to track an index and hope to beat the market by a small amount, the core-satellite approach may be the best route. For advisors and investors with more informed clients that minimize career risk concerns, the high-conviction route may be a better approach.

Good luck.