Factor investing has become a core part of the investment zeitgeist over the last decade or so, but as a practical matter investors sometimes have a hard time exploiting these risk factors in portfolios. That’s the conclusion of a recent study by BlackRock that analyzes 10,000 portfolios.

That’s a striking if not puzzling revelation when you consider 1) a deep pool of research shows that factor exposures are critical drivers of long-term portfolio risk and return; and 2) investors are, in fact, actively targeting factors. Something’s obviously amiss, although BlackRock’s analysis (and a new interview with one of the study’s authors) provide some insight into the disconnect.

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Let’s start with the research. “In the approximately 10,000 advisor portfolios that we analyze at the security level, we find there are large common patterns and significant exposures to just a few factors,” BlackRock analysts report in “Factors and Advisors Portfolios.”

Advisor portfolios are heavily exposed to economic growth, which is mostly accessed through equities, and could obtain better factor balance by including other diversifiers. Within equities, the only significant style exposure is small size; advisors, in general, can potentially improve returns by harvesting other rewarded style factors. In fixed income, advisor portfolios veer towards shorter duration which can be lengthened in an effort to provide more resilience against economic downturns.

A new interview with one of the paper’s co-authors — Andrew Ang, head of BlackRock’s factor strategies group – adds some context for what’s going on and how portfolio design can be adjusted to improve the effectiveness of factor exposure. “The most surprising insight was that while we have identified a variety of different factors that have historically driven returns over the long-run, investors currently only have meaningful exposure to two of these factors,” he says in a discussion on BlackRock’s blog this week.

Economic growth, a macro factor, is the main exposure, Ang notes. “And they probably have too much exposure to economic growth. meaning that their portfolios might lose more than they intended when the economy slows,” he explains. “Not surprisingly, stocks are sensitive to changes in economic growth, and thus stocks tended to be the primary driver of risk in the portfolios analyzed.”

The second biggest factor exposure is within the equity allocation. Actually, the key observation here is what’s missing. “Investors barely have any style factors” within the equity bucket, he observes.

The only style factor they have meaningful exposure to is low size, or more commonly thought of as smaller companies. However, we were very surprised to learn of the lack of diversification across style factors within the portfolios. Investors could potentially enhance returns or reduce risk by adding meaningful value, quality, momentum or minimum volatility factors.

Perhaps the most surprising finding is that some of the heavy bets on economic growth and low equity size are accidental. Rather, it’s an “unintended side effect of individual fund choices in a portfolio.”

This is no trivial issue, Ang notes, because different equity factors tend to shine or stumble at different points in the economic cycle. As a result, providing clean exposure to specific factors, and adjusting exposure through time, offers, in theory, significant benefits for risk management, which in turn boosts the potential for maximizing risk-adjusted performance.

As an example, the Q&A with Ang offers an idealized timeline of how equity factors can wax and wane over the course of the business cycle:

“Quality and minimum volatility strategies may offer investors the opportunity to diversify their factor exposure while also better positioning their portfolios for the current economic environment,” Ang advises. “As both strategies have historically outperformed in periods of market decline, investors may want to consider using these factors to build resilience into their portfolios.”

The caveat, of course, is that factor investing isn’t science, at least not completely. Like all investment strategies, a fair amount of uncertainty pervades the best-laid plans of engineering what appears to be an informed asset allocation design. Nonetheless, there’s probably no advantage to leaving a portfolio exposed to hefty unintentional factor bets, including bets that inadvertently exclude key factors, which seems to describe a fair number of strategies in the real world, according to BlackRock’s analysis.

The good news is that building a smarter factor allocation is straightforward. The solutions vary, of course, depending on the extent and type of an inadvertent portfolio design. As an example, Ang says “investors may be able to improve the resilience of their portfolio, particularly ahead of a potential economic slowdown, by doing one or two things:

* First, they may consider reducing their exposure to economic growth and increasing their exposure to other macro factors by selling stocks and buying treasury bonds.

* Second, investors can increase exposures to other style factors to add diversification or specifically to those that have done well in the later stages of the economic cycle.

Minds will differ on the details, of course. After all, no one has a monopoly on what will work, or not, for factor allocations in the years ahead. But one thing is clear: allowing your portfolio to drift into an unintentional factor allocation due to oversight is no one’s idea of a high-probability recipe for investment success.

Fortunately, designing and managing factor exposures with a high degree of control and precision is easy via the wide array of surgically precise factor ETFs and mutual funds – see here and here, for example.

Slicing and dicing portfolios based on macro factors – economic growth, credit, inflation, and other factors – is also straightforward. Indeed, some investors intentionally design strategies to focus on these influences directly and exclusively.

Factor investing, in short, comes in a wide variety of flavors. The only glitch: fully exploiting the potential benefits requires paying attention to asset allocation. Call it the Yogi Berra rule for factor investing: You can observe a lot just by watching.

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