We’re going to mix things up today and talk about a topic I’ve been meaning to get to for quite some time: factor investing. My original intention was to create an in-depth report on this topic – which I’m still planning to do – but today’s article will serve as preliminary attempt to get those juices flowing.
If you take a look at the home page for this site, you’ll notice that under the “Our Approach” section, it mentions Factor Investing. A brief, one-sentence explanation is provided: Factors are historically persistent drivers of returns within and across asset classes, that can be added to traditional portfolios to enhance returns.
While that may sound nice, you probably have no idea what it means … so let’s dig in a little deeper. As we go, I’ll try and explain a related concept – smart beta – which is really more of a marketing concept than anything else, but still important to understand as part of your investing vernacular.
Let’s begin with this. We know that stocks (and in particular U.S. stocks) must always play a key role in our investment portfolios because they’ve historically generated the highest risk premium. That is, the compensation provided to investors for bearing the risks of equity ownership has been substantially higher than with any other asset class.
Most of us have come to understand the wisdom of buying diversified indexes such the S&P 500, or Nasdaq Composite, but this leads to another question: Is there a better way to participate in stocks than through traditional capitalization-weighted indexes?
In case you’re not familiar, a cap-weighted index is one where the components are weighted according to the total market value of their outstanding shares. What this means in practice is that when you buy, say, an S&P 500 index fund, most of your investment is going to the largest companies within that index. The smaller the company (based on market-cap), the less of that company you’ll own.
Market-cap weighted indexes are generally considered the norm (except of course for the Dow Jones Industrial Average – which is price weighted), but decades of academic research has led to the realization that there may be better alternatives.
The reason I say “may” is because much of the academic literature, as we’ll see, is mixed. Depending on who did the studies, what logic they used, and what timeframes were incorporated, the results can sometimes differ. My goal in this article is to introduce you to the basic premise of factor investing (as well as smart-beta), and provide some background knowledge on when (and why) it can help improve your investment returns.
As we go through this, keep in mind that most of the so-called “factors” that we discuss are not necessarily new, but their prevalence and relevance changes as market conditions evolve.
Also, it’s important to recognize that even if the concept of factors is somewhat new to you, it’s adoption by the investment community is already widespread. According to BlackRock, the amount of money in factor-based funds is currently around $1.9 trillion, and projected to grow to $3.4 trillion by 2022.
Alright, now the fun stuff … When it comes to factors, it’s broadly accepted that there are two main types: macroeconomic factors and style factors. The former refers to macroeconomic variables that explain the bulk of returns across asset classes, while the latter refers to variables that explain the bulk of returns within asset classes.
In this article (and in the eventual report that this develops into) we’re going to focus primarily on style factors related to the stock and bond markets. However, you’re probably curious what the macroeconomic factors are, so let’s briefly go over those.
It should come as no surprise that returns across asset classes are a function of economic fundamentals. According to BlackRock research, over 90% of the returns across asset classes can be explained through six primary drivers of returns (factors). These are: economic growth, real rates, inflation, credit risk, emerging markets and liquidity.
We’re not going to go into detail on these macroeconomic factors now, because for the most part, they’re basic and easy to understand. If you’ve read my market commentary over the years, you’ve probably noticed that I touch on these subjects quite frequently (with the exception of perhaps emerging markets and liquidity) … that is not a coincidence.
Today, I want to focus primarily on the stock market, and understand the specific style factors related to equities.
Over the years, academic researchers have uncovered hundreds of so-called “market anomalies” which, for lack of a better definition, are predictable patterns in stock prices that should not exist if the market was truly efficient.
The problem is that as these anomalies, or factors, are discovered, they are exploited quickly (if they ever really existed, that is) and tend to fade away into oblivion. As decades of academic research on this topic has piled up, it’s become generally recognized that, like macroeconomic factors, there are also six equity style factors that can provide excess stock market returns.
Once again, I use the word “can,” because it’s important to recognize that these factors do not always provide excess returns above a typical cap-weighted index. Rather, their outperformance ebbs and flows in response to various factors.
You’ve probably heard of most of these equity style factors already, but they include value, size, momentum, quality, dividend yield and minimum volatility (min-vol).
We’re going to walk through each of these briefly, with an emphasis on the first three today.
The idea of value investing has been around for over a hundred years, and was pioneered by Benjamin Graham, who is considered the father of value investing. Another household name synonymous with value investing is Warren Buffett, who was one of Benjamin Graham’s students, and is considered perhaps the best investor of all time.
Buying “value” companies is a simple concept that involves looking for situations where you’re getting more than you’re paying for. Value can be measured in a variety of ways, but the most common measure used is the book-to-market equity ratio.
By sorting stocks within a particular index on this metric, one can come up with a “value” group, with the remaining companies often being categorized as “growth.” This delineation has become so common and ingrained in the investment community that even many 401(k) plans, which have notoriously bad investment options, will include value and growth versions of the typical small, mid and large-cap indexes.
Value investing was heavily popularized by Benjamin Graham and David Dodd, but its influence became even more pervasive after a seminal paper was written in 1992 by Fama and French, called “The Cross-Section of Expected Stock Returns.” That paper demonstrated a significant value premium, and led to an explosion in the number of investment strategies and funds incorporating a tilt toward value stocks.
Now, before we go any further, I think it’s important to point out that while value is considered one of the premier equity factors, it does not always provide an advantage. In fact, based on recent analysis from AJO Partners, growth has outperformed value over the last 5, 20, 25, 30, 35 and 40 years. (Keep in mind that this data is looking at growth vs. value in aggregate, whereas if we break growth vs. value down by, say, market-cap or sector, the results differ).
To help drive in this idea that value can deliver excess returns sometimes, but not always, take a look at the chart below. This chart plots the returns for three indexes, the S&P 500 (in red), the S&P 500 Growth (in blue) and the S&P 500 Value (in green), going back to 2000.
As you can see, value will often outperform during certain market environments, but growth will outperform during others. Over longer periods of time, the two tend to offer similar results.
This finding is backed by a more recent study completed by Isreal and Moskowitz in 2013. They reexamined the value premium and found it to be insignificant in the largest 40% of stocks on the NYSE. While still prevalent across smaller stocks, these finding call into question the idea of a universal value premium in the equity market.
Your overall takeaway from this should be that while value is still considered an important equity style factor, the value of this factor (no pun intended) is questionable and dependent upon market conditions as well as other equity variables (such as market-cap).
Thus, the next time someone mentions to you how valuable the “value premium” is, you can respond, “yes, but …”
Okay, so apparently I underestimated both how much detail I was planning to include regarding these factors, as well as how long it would take to tackle this topic. As a result, we’ve only made it through one of the equity style factors today …
Moving forward, I’ll figure out some way to finish addressing this topic while keeping you apprised of the latest technical and economic developments.
To provide some additional context, there are two primary reasons why I want to make sure you understand this topic in detail. The first is simply so that you’re a more informed investor and can use factor based ETFs as part of your overall investment approach. As I mentioned, the idea of factors (and related smart-beta) are gaining popularity and traction, but if not used properly, they can harm returns as much as enhance.
The second is because over the last few months, I’ve been working with a couple of colleagues to develop two investment models that will be used to manage client accounts through Sigma Point Capital. As you might expect, we will selectively utilize factor based ETFs as part of those investment strategies, so I want to make sure that those of you who are interested in managed accounts are up to speed and comfortable with all this stuff.
I realize today was an odd departure from our regularly scheduled programming, but hopefully you found (and will continue to find) it valuable. As always, questions and comments are appreciated.