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By Jeff Brown, CFADirector, Institutional Portfolio Manager, Parametric and James RoccasManaging Director, Investment Strategy, Parametric

Seattle & New York - When we think of the apex of customization, our minds are drawn to 7-Eleven, which became the first major retailer to offer self-serve fountain drinks in 1983. Up until that point, a customer ordered a soda, and someone behind the counter would fill it. But that glorious day marked the birth of the so-called Graveyard — a mixture created just for and by the customer, with whatever mix of carbonated beverage they liked.

Similar to beverage customization, investment customization has come a long way. Security selection is perhaps the best-known advantage of a customized separately managed account (SMA). Investors may be less familiar with the ways they can tailor their portfolios for yield enhancement. Let's take a look at one key approach.

How can investors use factors to enhance yield?

Using equities to customize for yield enhancement isn't a completely new invention. Investors have had access to a variety of dividend-focused strategies for years. One specific way to get access to yield enhancement is to use a dividend factor strategy.

Factor investing is an investment approach that involves targeting quantifiable firm characteristics, or factors, that can explain differences in stock returns. A few other popular factors besides dividend yield include momentum, value and quality.

A factor-based investment strategy involves tilting equity portfolios toward and away from specific factors in an attempt to generate long-term investment returns in excess of benchmarks. The approach is quantitative and based on observable data, such as stock prices and financial information, rather than on opinion or speculation.

This type of strategy is ideal for investors with a long-term focus and a willingness to accept higher risk in pursuit of higher excess return potential due to the factor risk premium. When used on a standalone basis, our research has estimated that the predicted tracking error1 of a factor strategy can range between 3% and 6%.

Investors may choose to blend factor strategies with a broad-based cap-weighted benchmark in order to limit that relative risk. A factor-based strategy may also be suitable for investors who seek to replicate the risk characteristics of an active portfolio, without paying higher fees for active management.

Building portfolios that attempt to maximize exposure to a specific factor may bring along bets that certain investors might not be aware of. Focusing on dividend yield exclusively will tend to build portfolios that overweight certain dividend-paying stocks in the financials, industrials and energy sectors. This is why some factor-based strategies provide investors with the ability to maximize certain factor exposures while still constraining the unintended exposures that come from that type of investing.

Bottom line: Yield enhancement through factor investing can offer investors the opportunity to adjust their portfolios to meet their specific criteria. Since no two investors are alike, achieving these goals can look different for each of them. But the ability to create the right mix to meet every investor's individual needs is something that we can all agree tastes good.

1. Tracking error is a measure of the risk in an investment portfolio relative to its benchmark index, which results from active management decisions made by the portfolio manager.