A map to building factor-based portfolios

The Vanguard team looks primarily at the mechanics and trade-offs of two factor approaches:

• Market-capitalization weighting, which entails identifying stocks with the desired factor exposure and assigning each stock a portfolio weight based on its relative market cap.
• Signal weighting, which starts with a calculation of the specific factor exposure of a set of stocks and then bases portfolio weight on each stock’s relative exposure to that factor without regard to the stock’s market cap.

"Our paper seeks to educate advisors as well as their clients on the different approaches to factor construction and their trade-offs," said Victor Zhu, CFA, CAIA, one of the paper’s authors.

An investor who strongly believes in the value factor may want to achieve a certain target exposure to value in an overall portfolio. After taking their risk appetite, investment objectives, and existing asset allocation into account, the investor could choose either a cap-weighted or a signal-weighted approach to achieve that exposure.

"The way that is the most familiar to investors is market weighting," said Haifeng Wang, Ph.D., CFA, another of the paper’s authors. "For the value factor, if you pick the top one-third of 1,000 stocks with the highest value score—however you define value—and then you use the market cap to weight for those stocks, that’s the market weighting. For signal weighting, we calculate the value score, and we use the score to weight each stock."

That distinction can make a significant difference. For example, as the accompanying graphic shows, an investor starting with a 60% stock/40% bond portfolio would need to allocate 30% of the overall equity assets in a cap-weighted factor fund versus 19% in a signal-weighted factor fund to reach the same targeted value exposure.

The cap-weighted allocation would be expected to deviate less from the broad market but would require a larger capital commitment to achieve a similar factor exposure. The signal-weighted allocation would achieve the same targeted factor exposure more efficiently but would deviate more from broad market returns, adding risk.

The authors argue that factors can be a useful tool for seeking enhanced returns, expressing a directional view on the market, and potentially reducing risk in an investor’s portfolio. Understanding the trade-offs and nuances of different factor approaches may help investors optimize their portfolios and achieve their investment objectives, the authors say.

"Different factors often exhibit low correlations with each other, which means that when one factor is underperforming, another may be outperforming," Zhu said. "This can help reduce the overall risk in a portfolio."

The paper takes an impartial view toward the approaches. "We do not want to make a recommendation for which weighting scheme to use," Wang said. "We just want our readers to be mindful of the risk–return trade-off."

As Zhu put it: "Factor investing is not made for everyone. Depending on one’s investment objective, risk tolerance, horizon, and expertise, a factor fund can be used as a tool to enhance return or diversify real risk, depending on how the investor wants to structure the portfolio." 

• Striking while the iron’s hot for factor premia (article, issued June 2023)
• Portfolio construction: Principles inform possibilities (article, issued August 2022)
• Vanguard’s portfolio construction framework: From investing principles to custom portfolio solutions (32-page PDF, issued July 2022)