Key Points:
- Equity factors play a crucial role in a goals-based investment approach
- Factors such as Small Minus Big (SMB), High Minus Low (HML), Robust Minus Weak (RMW), and Conservative Minus Aggressive (CMA) can contribute to growth, income, preservation, and liquidity goals
- Factors have different correlations with market returns and macroeconomic conditions
- Convexity and skewness of factors can determine their behavior in different market environments
- A diversified factor portfolio can provide better performance during bear markets with lower volatility
Our 4×4 Asset Allocation philosophy focuses on four main goals: Growth, Income, Preservation, and Liquidity. Under the 4×4 Goal Parity framework, each of these goals has equal weight. When applying a goals-based approach to equity factors, factors such as SMB, HML, RMW, and CMA can contribute to these goals in different ways.
The correlations between factors reveal interesting insights. For example, the market’s excess return (Mkt-RF) is negatively correlated with factors such as SMB, HML, and RMW, while it is most negatively correlated with CMA. This suggests that CMA may be a defensive factor. Furthermore, HML and CMA have a 68% correlation, indicating the potential role of HML as a defensive factor as well.
An analysis of the convexity and skewness of factors provides additional insights. Factors with positive co-skewness with a risk factor are convex, while those with negative co-skewness are concave. Factors such as CMA and LT_Rev exhibit convexity, indicating better performance in crises driven by rapid changes in interest rates or market declines.
When constructing a factor portfolio with an equal-weighted approach, the performance patterns of the portfolio differ from the market. The factor portfolio tends to lag behind the market during bull markets but performs better during bear markets with lower volatility. This suggests that a diversified factor portfolio can provide resilience and better risk-adjusted returns.
Overall, a goals-based approach to equity factors can help investors achieve their investment objectives by considering the contributions of factors to growth, income, preservation, and liquidity. Diversified factor portfolios balanced across these goals can enhance performance and provide a smoother ride in different market environments.
