Evaluating Factor-Based Strategies: Fidelity's Investment Approach

Factor-based investment strategies are founded on the systematic analysis, selection, weighting, and rebalancing of portfolios, favouring stocks with characteristics that have proven to enhance risk-adjusted returns over time. Fidelity's factor-based investment strategies are backed by decades of fundamental research and systematic tools and quantitative expertise. In this article, we will discuss how to evaluate factor-based investment strategies with Fidelity, including an overview of factor investing, the benefits of factor-based strategies, and the role of quantitative actively managed funds.

Fidelity's factor-based investment strategies

Factor-based investment strategies provide investors with targeted and streamlined access to factor exposures. Fidelity's factor strategies aim to manage asset-specific risk and high portfolio concentration, with a neutral size exposure that helps avoid unplanned sector bets. The company's factor-based investing options can offer insight into historical risk and return drivers, help target precise exposure, and express investment views while managing unintended risk.

Fidelity offers a range of factor-based investment products, including ETFs and mutual funds, that provide exposure to multiple factors within a single vehicle. These products can help investors meet certain investment objectives, such as potentially improving returns or reducing risk over the long term.

How factor investing improves risk-adjusted returns

Factor investing is a strategy that selects securities based on attributes associated with higher returns. These attributes, or factors, can be used to explain and analyse asset prices and build an investment strategy.

Factor investing can improve risk-adjusted returns in several ways. Firstly, it can provide insight into historical risk and return drivers, helping investors make more informed decisions about their portfolios. For example, empirical research suggests that stocks with low volatility earn greater risk-adjusted returns than highly volatile assets. By understanding these factors, investors can make more strategic choices to improve their risk-adjusted returns.

Secondly, factor investing can help target precise exposure to specific types of securities. For instance, a fund based on the quality factor would focus on companies with superior profits, strong balance sheets, and stable cash flows. This approach allows investors to seek out securities that align with their risk tolerance and investment goals.

Additionally, factor investing can enhance diversification within a portfolio. Different factors, such as size (large cap vs. small cap) and style (growth vs. value), tend to perform well at different times. By investing in multiple factors, investors can reduce the risk of their portfolio being affected by the cyclicality of individual factors.

Factor investing also allows investors to benefit from long-term trends. For example, small-cap stocks have historically outperformed large-cap stocks over longer periods, and value stocks with low prices relative to their fundamentals have generated greater returns than the broad market.

Finally, factor investing can be used to complement traditional index or active investments in a portfolio. It can be a powerful tool for investors to enhance their risk-adjusted returns and build a more robust and resilient investment strategy.

Smart beta strategies

Smart beta funds do not follow standard indices like the S&P 500 or Nasdaq 100 Index. Instead, they focus on areas of the market that offer opportunities for exploitation. These strategies are typically implemented using transparent, rules-based index construction.

Smart beta funds have continued to attract investors despite typically attracting higher fees than their vanilla counterparts. As of February 2019, smart beta funds held $880 billion in total cumulative assets, with a 10.9% increase in assets under management over the previous year.

Factor investing and portfolio construction

Factor investing is a key component of the investment process and philosophy. Factors are characteristics of securities that can help explain risk and return. There are six widely adopted factors identified by investors: size, value, momentum, quality, dividend yield, and low volatility. These factors are at the core of "smart" or "strategic" beta strategies and are investment characteristics that have tended to enhance portfolios over time.

Factor-based investment strategies can provide investors with targeted and streamlined access to factor exposures. The factor-investing universe is broad and extends beyond single-factor strategies targeting the six key factors. Many factor-based strategies provide exposure to multiple factors within one vehicle.

When constructing a portfolio, investors can use a combination of factors that align with their investment goals and risk profiles. For example, investors may consider factors such as low volatility, dividends, or quality. By incorporating factor-based exchange-traded funds (ETFs) into their portfolios, investors can help meet certain objectives over the long term.

Factor performance tends to be cyclical, and factor returns are generally not highly correlated with one another. Therefore, investors can benefit from diversification by combining multiple factor strategies. Factor-based investments are founded on the systematic analysis, selection, weighting, and rebalancing of portfolios in favour of stocks with certain characteristics that have been proven to enhance risk-adjusted returns over time.

Fidelity's approach to factor investing includes using decades of quantitative research and fundamental analysis to create factor-based indexes that seek to outperform broad-market indexes. Fidelity offers a range of factor ETFs, such as the Fidelity Dividend Factor ETF, Fidelity Low Volatility Factor ETF, and Fidelity Value Factor ETF, that provide investors with strategic factor-based investing approaches to help achieve their financial goals.

Factor investing vs traditional index products

Factor investing is a strategy that selects securities based on attributes associated with higher returns, such as macroeconomic factors and style factors. This approach aims to enhance diversification, generate above-market returns, and manage risk. On the other hand, traditional index products, like tracker ETFs, are designed to "buy the market" by following a specified market or index. While these traditional products offer high transparency, investors are fully exposed to the market's volatility.

Factor investing has gained popularity due to its ability to target specific factors and potentially improve returns or manage risk. Factor ETFs, for example, deviate from simply moving with the market and can be biased towards certain factors like small firms or stocks with accelerating value. This "tilt" allows investors to potentially achieve better returns without the high costs and time commitment of stock picking. Additionally, factor-based portfolios can be back-tested over long periods, helping to analyze their robustness.

However, factor investing also has its challenges. The large number of factors to choose from can be overwhelming for investors, especially when compared to the relative simplicity of traditional portfolio allocations. Factor investing also faces liquidity issues until it gains wider acceptance.

Traditional index products have their advantages as well. They are well-established and easy to implement, making them a familiar choice for investors. Additionally, experienced managers of traditional funds can leverage their expertise and qualitative information for portfolio construction, which may be more challenging to incorporate into a factor-based model.

Ultimately, both approaches have their merits, and investors should evaluate including both factor-based and traditional discretionary investing in their allocation. Factor investing can provide enhanced diversification and return potential, while traditional index products offer a straightforward way to gain market exposure.

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