Enhancing portfolio construction with factor investing

At the same time, longer life spans coupled with rising care costs significantly increase expected cash outflows for clients later in life. Elevated housing prices, high mortgage rates and escalating rents have made the dream of home ownership tenuous for many young Canadians and forced many retirees to dip into their savings to help their children. Meanwhile, a decade of constant tax increases has added to the retirement challenges of affluent Canadians.

In this environment, advisors should consider factor investing to enhance their portfolio construction. Factor investing is a strategy that involves selecting securities based on specific attributes or “factors” that have historically been associated with higher long-term returns.

Broadly speaking, in the equities market, these factors can be distilled into the following categories:

• Momentum. Stocks with positive momentum — i.e., those that have performed relatively well over the past six to 12 months — have outperformed on average stocks that display negative momentum.
• Quality. Over long time horizons, stocks with superior profitability in relation to capital have on average outperformed firms with poorer profitability in relation to capital.
• Low volatility. Low volatility stocks have on average outperformed stocks with high volatility.
• High yield. Stocks of companies that pay higher dividends have earned superior returns to lower and non-dividend paying stocks over the long run.
• Value. Stocks that are low-priced in relation to earnings, dividends, cash flow or book value on average have outperformed growth stocks over long time horizons.
• Size. Over long time periods, stocks of small and mid-size companies have earned on average higher returns than those of large companies.

There are two primary explanations for the higher returns associated with these factors. One is that the higher returns represent risk premiums — i.e., compensation to investors for incremental risks. For example, small-company stocks are not only more volatile than stocks of large companies but are also much less liquid. And value stocks tend to include a higher proportion of more indebted companies, which underperform the overall market during periods of extreme market stress.

The second explanation is offered by behavioural finance. Investors’ cognitive biases, such as myopia and overconfidence, lead to the persistent mispricing of certain securities. For example, many investors are attracted to the episodic outsized returns of highly volatile, low-quality stocks and chase these types of stocks despite a pattern of longer-term underperformance, leaving low-volatility stocks to outperform. Optimistic investors overestimate the earnings prospects of growth stocks while underestimating those of value stocks. The herding behaviour and overreaction of investors has been advanced as explanations for the superior returns associated with the momentum factor.

There are five reasons advisors should consider factor investing as a key part of their portfolio construction.

1. The potential for outperformance is likely to persist. The root causes of factor outperformance — either risk or investor psychology — are structural in nature. Numerous studies covering multiple markets over multiple decades provide evidence of the outperformance. This result contrasts with the idiosyncratic nature of active management, which requires a decade plus of outperformance to begin to separate skill from luck, and for which returns typically are no more persistent than random chance would provide.

2. Factor outperformance has historically been strong in Canada. Based on MSCI indexes, momentum outperformed the broad market in Canada over the past 10 years — 9.7% versus 7.4% per annum. Low volatility and quality also outperformed, each returning 8.6% annually. Value and high dividend yield edged ahead of the broad market, with 7.8% and 7.5% returns, respectively. Small cap, which has been challenged since the heady days of energy and materials exploration and development ended, underperformed, with a 5.7% annual return; however, it outperformed over a 15-year time frame.

3. Factor strategies can be implemented through a range of low-cost ETFs, which reduces the drag of expenses on a client’s portfolio performance. Survey research indicates that Canadian investors are concerned about fees, and this issue will only increase with the implementation of total cost reporting in 2026.

4. Factor strategies can be allocated within the household for optimal tax effectiveness. For example, a Canadian high dividend yield ETF or fund can be allocated to a household member for whom Canadian eligible dividends would be the most tax-effective form of income. A momentum-based strategy can be allocated when capital gains are the preferred form of return.

5. Factor-based strategies are available within certain liquid alternatives, hedge funds and private pools. These can combine multifactor strategies with leverage, shorting, timing and fundamental stock selection in the pursuit of superior risk-adjusted returns. Several studies have found that many hedge funds have demonstrated skill in enhancing returns through factor timing.

Like any investment methodology, there can be lengthy periods of underperformance in a particular factor, so diversification by factor strategies is recommended.

Overall, factor investing provides a low-cost method to pursue superior returns over the long run.

Michael Nairne, RFP, CFP, CFA, is president and CIO of Tacita Capital Inc., a private family office, and manager for TCI Premia Portfolio Solutions.