Factor investing the approach that targets specific drivers of returns, often across asset classes, and enhances portfolio construction through identified traits in equities or fixed-income investments has seen a push towards traditional markets. However, it can be applied to a wider range of asset classes than simply those considered traditional. In this article, we delve into how factor investing might apply to alternative assets such as real estate and commodities or other non-traditional investments.
Understanding Factor Investing
I want to give a quick explanation of what factor investing is first before then talking about how to incorporate it into alternative assets. Factor investing encompasses a range of related investment approaches that focus on intended using information about these underlying drivers and other observable market inefficiencies to achieve targeted excess returns by including or excluding firms based on this knowledge. What do equity markets have in common?
Growth: Stocks that have above-average earnings prospects while value is the term for those stocks that seem to be cheaper against their fundamentals.
Momentum: This type of stock is a big performer in the near short past.
Asset: CapitalisationStocks (good ballsacesheet and margins)
Small: Smaller companies that have historically beaten larger ones over the long haul
What is low volatility: Stocks with less movement in price
Ideally, by focusing on these factors, investors could achieve higher risk-adjusted returns relative to traditional market-cap-weighted indices.
Factor Investing in Real Estate
Factor investing is a natural fit for the real estate market. Ways Factors are Applied to Real Estate Investments
On value: In real estate, you can assess the intrinsic value of properties easily by key metrics like price-to-rent ratios, cap rates, and price-to-replacement costs. If property developers are skeletons in disguise, then value investors might note the ones trading at discounts to fair value and pounce on the best prizes.
Momentum — This can be implemented by rotating to areas with good recent price development and growing rental demand.
Value-added: Generally refers to sub-investment grade (BBB-), non-benchmarked bonds. Property QualityIn real estate, quality might refer to properties in A locations with low tenant rollover and maintenance requirements.
City: City real estate might be smaller capitalization (though this isn’t as clearly defined as in equity markets which have size categories), but such property development would likely still take place towards less developed cities.
Stable: This might mean focusing on properties or REITs that have consistent occupancy and cash flow.
Factor Investing in Commodities
A potentially more interesting area for factor investing is commodities.
Value: This might mean buying commodities that are cheap relative to their production costs or long-term averages.
Momentum: Momentum in commodities is defined as trend following, or buying those with price trends on the upside and selling those that have taken a downtrend.
Carry Commodity-specific, carry goes long high roll yield commodities (where future prices are lower than spot) and short low.
Low volatility reasons: Some commodity prices are less volatile than others, and those might be of interest in a low volatility strategy while other investors will seek to obtain the volatility premium present with more erratic commodities
Other Alternative Asset Classes
It is now also possible to expand the use of factor investing from equities to other alternative asset classes.
Investing in Private Equity: Your standard factors including value, quality, and size were used when it comes to investing in private companies.
Hedge Funds — A lot of hedge funds are indirectly factor bets (e.g. momentum in trend-following and value in distressed debt).
Infrastructure: Quality and low volatility factors are key in infrastructure investments, which can be a source of consistent future cash flows over the long term.
Cryptocurrency: Despite being a relatively new domain, there is some work by researchers trying to find out variables that might affect cryptocurrencies like momentum and size.
Challenges and Considerations
Though the potential for factor investing in alternative assets is huge, it also presents several challenges:
Limited Data: A key challenge in alternative investing is data scarcity with non-traditional investments as they often lack the extensive history of stocks and bonds, which can make modeling factor identification and testing very difficult.
Less Liquidity: Alternatives are frequently less liquid than traditional assets, which can make it more difficult to execute a dynamic factor strategy.
Sortino also notes that, since alternative assets are typically very heterogeneous (for example, no two real estate properties are the same), this can complicate factor analysis.
Cost: The implementation of factor strategies in alternative assets can be costlier as there are higher transaction costs and management fees.
Conclusion
If factor investing in traditional asset classes was the Wild West of investment strategy, then this new concept is a front tier. By building factor-based products out of real estate, commodities and other alternative investments investors might find otherwise untapped sources of returns and diversification. However, it needs to be carefully adapted based on the characteristics of different types of assets and practical implementation difficulties.
As we continue to do more research in this space, there will likely be additional clever implementations of factor-based strategies throughout the rest of the alternative investment universe. Factor investing in alternative assets is a fertile ground for a knowledgeable investor seeking to expand their toolbox, bolster portfolio performance, and manage risk.