Time to take a closer look at factors

With one of the most enviable pension systems in the world, an increasing number of Australian investors are taking the hunt for retirement income into their own hands through the establishment of an SMSF.

There are now more than 596,516 SMSFs in Australia, an increase of 28,301 from June 2016 and an increase of 96,350 from June 2012. However, in today’s unpredictable and challenging investment environment, investors are still grappling with how best to navigate different market cycles while generating reliable income.

Attempting to time the market is difficult for amateurs and professionals alike, however, through the use of strategies such as multi-factor smart beta, investors can help navigate different market cycles using factors that are known to outperform the broad market over the long term.

Home bias v global exposure

Australian investors hold a strong home bias and, so far, that home bias has served investors well. The allure of franking credits in addition to annualised returns has made a dependency on Australian shares almost irresistible to the majority of Australian investors.

Despite being considered somewhat of a safe harbour by many Australian investors, the local economy is highly concentrated on just a few key sectors. The big four banks made up over 23 per cent of the Australian market as at 1 January 2018. Remember when BHP was over 10 per cent of the market? It’s now at 5.39 per cent.

Against the backdrop of a commodity super cycle that has been and gone, years of falling interest rates and a booming housing market, Commonwealth Bank of Australia (CBA) has taken the place of BHP as the largest stock in the Australian market at over 8 per cent (8.05 per cent at 1 January).

While there’s no denying that the banks have served Australian portfolios well, taking over from the miners during the past decade, financials now serve as the dominant sector in Australia at 40 per cent, representing just 18 per cent of the world portfolio. Similarly, Australia is heavy on materials at 17 per cent, compared to the world at 5 per cent.

SMSF investors do not buck this trend. As of June 2017, SMSF investors held $212.21 billion in Australian listed shares, compared to just $4.37 billion in international shares. Just 2 per cent of SMSF asset allocation lies in international shares.

Enter exchange-traded funds

Exchange-traded funds (ETF) are baskets of securities that are traded on the Australian Securities Exchange just like single stocks. A key difference between these vehicles and shares in, say, CBA or BHP is that the value of ETF shares is backed by the value of the broad basket of stocks they invest in, not the value of one company.

ETFs allow investors to access particular themes, sectors and markets; importantly, they offer a simple way to mitigate risk through portfolio diversification. For investors looking to defensively position their portfolios against volatile markets, the development of more sophisticated vehicles such as multi-factor smart beta enables investors to adopt a strategy that uses the power of factors for a more consistent and smoother return stream over the long run.

While passive strategies will typically select stocks based on their market capitalisation relative to the index, smart beta strategies differ in that they are instead weighted according to desired factor exposure.

Diversifying across factors

As the only ‘free lunch’ in investing, diversification offers investors greater risk control and a smoother investment journey. It’s not about picking the next hot stock or taking on more risk, it’s about having the right exposures to guide the direction of your investment journey.

When we talk about factors, we are talking about employing an intuitive investment approach – we know investors would want to buy low and sell high (value), invest in companies that have viable businesses (quality) and demonstrate reasonable stability (low volatility). Essentially, factors are the elements that drive portfolio returns.

Traditionally, factors have been used to meet a particular objective, however, more often than not investors have multiple objectives and could look at a combination of factors to achieve them. Along with their objectives, investors must also consider the cyclicality of single factors, which are disposed to periods of underperformance because of trends in the business cycle.

Through using a strategy that offers consistent exposure to value, quality and low volatility (regardless of market conditions), investors don’t need to focus on timing the market, but instead can grow returns through time in the market.

For investors who require the benefits of long-term growth and income stability, a global multi-factor smart beta approach aims to deliver consistent exposure to multiple factors without the need for a crystal ball for stock selection and regardless of market ambiguity.

Whether used as a core equity strategy or as a satellite fund, investors can consider implementing a global multi-factor smart beta strategy through funds like the SPDR MSCI World Quality Mix Fund to play a variety of roles in a portfolio.

Factors, smart beta and portfolio performance

We believe the transparency of ETFs, combined with the benefit of factor exposures, makes multi-factor smart beta an important strategy for investors to consider when searching for a smooth ride in markets that just won’t stand still.

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