Style Research applies six criteria to identify a factor framework for effective fund identification, comparison, and research. Our “Effective Factors” blog series provides a deep look at the criteria. In our final post in the series, we discuss the importance of factors being easy to understand and communicate in order to form clear decisions and build trusting relationships between fund managers, investment consultants and asset owners.
Suppose you are evaluating an investment manager who claims their equity fund is currently invested in small value stocks together with a bias to quality and high momentum. Which do you think would be more helpful for you to verify this claim quickly – the table of portfolio characteristics (Table 1) or the more visual chart below (Exhibit 2)?
The Art of Portfolio Factor Analysis
Unfortunately for investors, fund fact sheets often just present tables of portfolio characteristics in an attempt to convey style factor exposures. While seemingly transparent, these don’t usually help much in the fast understanding of style or factor orientation. How much higher or lower is the portfolio number compared with the benchmark? How significant are the differences across factors? And how much of these differences might be driven by sector or country differences rather than genuine factors?
The visualization of data may seem like a trivial exercise, but transforming raw numbers into visual insights often requires some careful consideration. It’s not just about drawing pretty pictures. The methodology underlying the numbers that are being visualized also needs to be transparent and easy to understand, but not oversimplified. For example, some naive approaches distort portfolio factor exposures by neglecting to incorporate the diversification of the portfolio or by treating the benchmark as a random sample. Conversely, some complex approaches become too opaque to be readily understood without having a Ph.D. in statistics. This is where the real-world investment practitioner experience of managing money can be integrated with quantitative know-how to craft insightful visualizations of portfolio factor analysis.
Communication Is Not Just for Sales and Marketing
Investment managers need to differentiate themselves from the rest of the pack. A visual display of clear portfolio information can help their clients or prospects digest proof statements of their investment process more quickly and with confidence. Since each investment approach and set of current investment views are usually loaded with a great deal of proprietary detail, it becomes valuable to use an objective and independent standard to translate key portfolio insights into a common language. But these are not just for external communication. Communication within an investment firm is also vital to ensure that portfolio managers, client-facing teams, business development teams, senior investment committees, quants and non-quants are all on the same page. Everyone should understand the key aspects of their current funds’ factor exposures, for portfolio reviews, fund positioning in the market, and for investment decision-making. Using tools to construct or optimize a portfolio and then using the same tools to evaluate factor biases and risk can produce a false illusion of comfort. An independent and objective lens offers a more neutral basis for communication, both internally as well as externally.
Transparency Builds Trust
There’s an even more fundamental reason to provide visual factor results built on top of a transparent and understandable factor methodology. That is to serve the client. Since the investment arena is fiduciary-based, transparency and trust should be undisputable tenets. Doesn’t it make sense that a portfolio analysis ought to be consumable by the ultimate investor or asset owner? After all, the fulfillment of a fiduciary responsibility demands rigorous assessment of funds and knowing if a fund is a good fit with the investor’s stated investment views and risk preferences. Asset owners or their consultants may have to assess hundreds if not thousands of investment funds to do a proper job of due diligence. Using an objective factor framework where the methodology is transparent and where the analysis is visual provides much more effective communication between asset owner, consultant, and investment manager. That in turn builds confidence, trust, and lasting relationships.
Style Research Criteria for Effective Factors
Explore the Style Research criteria for identifying an effective analytical factor framework, or see a quick snapshot of all six of them in our related infographic. For greater depth of these criteria, read more in the Effective Factors blog series.