The toy box portfolio for charities and endowments

Key takeaways 

·         Factor investing targets characteristics such as quality, momentum, value, low risk and size.

·         Multi-factor investing combines several factors in a single portfolio, helping to diversify* sources of return and reduce reliance on any one investment style or market trend.

·         For charities with long-term assets seeking equity-like returns, we believe factor investing could provide an alternative to traditional market-cap-weighted equity index funds or traditional active funds.

For charities, long-term capital is exactly that, and endowments, reserves and strategic assets are often invested with a horizon measured in years or even decades.

Many charities continue to hold significant cash balances. Understandably so. Cash can provide certainty and liquidity, but inflation can gradually erode purchasing power. Trustees looking beyond cash and comfortable with higher levels of risk often face a familiar dilemma: how to pursue equity-like or even higher returns in the most efficient way i.e., avoiding concentration traps and minimising the drag of fees and charges on long-term returns.

Perhaps the answer lies somewhere rather unexpected: Andy's toy box.

If you've ever watched Toy Story, you'll know the story changes dramatically when Buzz Lightyear arrives. Suddenly every toy in the room becomes captivated by the shiny new arrival and the entire toy box revolves around one character.

Markets have a habit of behaving in the same way. Traditional global equity indices are typically built according to market capitalisation. The larger a company becomes, the bigger its position in the index; the index can then become increasingly concentrated, and a handful of companies may have a disproportionate impact on performance.

There is nothing inherently wrong with this. Many charities achieve long-term returns through market-cap index investing. Yet some investors look at Andy's toy box and wonder whether one captivating toy is the only way to tell the story. After all, the success of Toy Story never depended on Buzz Lightyear alone.

The whole toy box approach

One of the enduring lessons of Toy Story is that no single character is responsible for every successful adventure.

Woody brings reliability and leadership. Buzz brings confidence and momentum. Rex reminds everyone about risk. Bullseye adds speed and agility. Even Mr Potato Head contributes a perspective nobody else can provide.

Factor investing starts from a surprisingly similar observation. Rather than owning companies solely based on their size, multi-factor strategies seek to target specific characteristics that have historically influenced investment returns. 

In essence, they ask a simple question: are there identifiable traits that help explain why some securities perform better than others over long-term? Within equities, the most commonly recognised factors include:

Woody is quality

Woody is dependable, trusted in a crisis and usually the one holding things together. Quality companies tend to have strong balance sheets, healthy profitability and resilient business models.

Buzz Lightyear is momentum

When Buzz arrives, he's exciting and has a compelling story. Momentum investing seeks companies that have performed strongly on the belief that trends may persist for a period.

Rex is low risk

Rex is cautious and anticipates potential issues around the corner assumes disaster is just around the corner. Low-risk investing favours companies with historically lower share-price volatility which may be overlooked by investors.

Bullseye is size

Bullseye is quick, nimble and capable of getting places larger characters cannot. Smaller companies have historically offered higher growth potential, albeit with a bumpier ride.

Mr Potato Head is value

Mr Potato Head is often unloved and underestimated. Value investing seeks attractively priced companies whose assets might be undervalued by the market.

Factor investing seeks to capture exposure to these characteristics systematically through rules-based index strategies. They can provide a disciplined framework for expressing investment beliefs and building portfolios differently from traditional market-capitalisation-weighted benchmarks but preserving the transparency and cost-effectiveness of the index approach.

Factors can provide an additional source of diversification* beyond traditional market-cap indices, offer a systematic and transparent investment approach and often come at a lower cost than many active management strategies. For trustees seeking a different route to equity-like returns, that combination may be worth considering.

Not every hero saves every adventure

One of the most common misconceptions about factor investing is that it should always outperform traditional market-cap indices. It won't.

The objective is not perpetual outperformance. It is to gain exposure to characteristics that investors believe may be rewarded over the long term. Like the toys in Andy's bedroom, different characters shine in different chapters of the story.

One aspect of factor investing is that two strategies with the same label can look remarkably different. Some providers use straightforward and transparent methodologies, while others rely on more complex proprietary approaches. The key question for trustees is whether any additional complexity justifies the extra governance responsibilities.

After all, a strategy that nobody around the trustee table can explain during a difficult market period is rarely a comfortable place to be. Complexity itself is not evidence of quality.

For charities especially, transparency matters. Trustees have responsibilities not only to generate returns but also to understand the risks being taken on behalf of beneficiaries.

The toy box portfolio

The lesson of Toy Story isn't that Woody is better than Buzz, or that Rex should replace Bullseye. It's that Andy's adventures worked because the toy box contained all of them. 

Multi-factor investing follows the same principle. Quality, momentum, low risk, size and value each experience periods of strength and weakness. The challenge is that nobody knows in advance which factor may be the hero of the next (market) chapter.

A multi-factor strategy is therefore like building a well-stocked toy box. Investors combine a collection of different strengths in the hope of creating a more balanced and resilient portfolio over time.

Of course, every Toy Story film contains moments when the hero's plan doesn't quite work out as expected. Factor strategies all still invest in equities even if their components and their weights might differ. When broad global equity markets experience a drawdown, equity factor strategies might still experience negative returns, though to a varying degree.  

In the next article, we’ll explore alternatives, outside of publicly listed equities, available to charities seeking these higher long-term returns. 

 

*It should be noted that diversification is no guarantee against a loss in a declining market

Capital at risk. The value of an investment and any income taken from it is not guaranteed and can go down as well as up, and investors may get back less than the amount originally invested.

This article is provided for information purposes only and does not constitute investment advice or a recommendation. Trustees should consider their own objectives, circumstances and professional advice before making investment decisions.