- Research has associated certain attributes of stocks with excess returns. These are called factors.
Examples of factors include: value, momentum, quality and low volatility.
Like any rules-based strategy, factor investing can have patches of underperformance.
The Rise of Factor Investing
In recent years, a new approach to investing has gained significant attention among both institutional and individual investors: factor investing. Factor investing challenges the efficient market hypothesis and revolves around systematic and empirically tested strategies that have generated excess returns. This article delves into the concept, its key factors and possibilities for individual investors.
Understanding Factor Investing
Factor investing is based on selecting securities that have certain attributes that have been associated with excess returns. It is based on a systematic, rules-based approach that follows a strict model for decision-making. It’s a more quantitative way to manage a portfolio; the analyst takes the backseat and has minimal input. Therefore, factor investing differs from the so-called ‘active investing’, where the buying and selling of securities is done at the manager’s discretion, and the returns earned depend on his ability. Factor investing is also not ‘passive investing’, which is also based on a rules-based system but only tracks the market’s return.
Source: MSCI, ‘The foundations of factor investing’, December 2013.
Due to the increasing popularity of this strategy, an overabundance of factors has surfaced in the academic literature, leading to a “zoo of factors”. Nonetheless, most of these are very similar to each other and essentially measure the same phenomenon. Of all the factors that have been tested, only a select few are widely recognized as characteristics that actually enhance returns. The table below shows the most common factors:
Source: Robeco Factor Investing
As depicted above, the major asset managers and index providers agree that quality, momentum, value and low volatility are traits that have led to outperformance. Additionally, a second set of factors: size, dividend yield and income, are elements that could also be exploited. The second set of factors could be combined with the first one, for example, quality stocks that pay a high dividend or small-cap value stocks. For this reason, this article will focus on the first four factors.
The value factor is based on buying assets that are cheap relative to their fundamentals. The point is to benefit from discrepancies between price and intrinsic value to buy undervalued assets. Put simply, the value factor is based on paying 50¢ for something that is worth $1. For example, the model will identify companies that are trading for low valuation ratios (e.g. EV/EBIT or P/FCF). Then, it will assess aspects such as profitability and solvency to determine if a higher price is warranted. Conversely, if a stock is worth $1 based on its fundamentals but is trading at $1.5, then a short position is taken. Value performed well for several decades but has had a rough patch since 2008. This factor tends to shine during downturns because it is focused on minimising downside risk: an expensive stock that is trading for high multiples relative to its fundamentals is poised to go through a bigger decline than one which has already been beaten down. Examples of value ETFs include the Vanguard Value ETF (VTV), iShares S&P 500 Value ETF (IVE), the Acquirer’s Fund (ZIG) and the Alpha Architect US Quantitative Value ETF (QVAL).
Source: Yahoo Finance
The momentum factor is all about following stocks that are trending in a particular direction. The strategy evaluates price performance over the past six to twelve months and then buys securities that are steadily going up and sells those that are steadily declining. In this sense, fundamentals are mostly irrelevant for momentum investors; price action is all that matters. Although momentum might seem as the opposite of value, one could argue that they are two sides of the same coin: both strategies are based on exploiting the madness of crowds. Whether it be steady price appreciation due to irrational exuberance or a discount relative to fundamentals as a consequence of profuse pessimism, both strategies attempt to profit off mispricings, but one of them finds dislocations between fundamentals and price while the other rides price action for as long as possible. Momentum is versatile in the sense that it can work in many macro environments; after all, it's based on following price action, which can be done under any market conditions. During this millennium, momentum’s performance has been stellar:
Source: MSCI Factor Factsheets: Momentum
Over a longer time frame, it has underperformed value but still outperformed a world index (see the long-term performance chart further down). Some momentum ETFs are: Vanguard US Momentum Factor ETF (VFMO), iShares Edge MSCI World Momentum Factor UCITS ETF (IWMO) and Alpha Architect US Quantitative Momentum ETF (QMOM).
Next, the quality factor identifies companies that have outstanding fundamentals, such as high and consistent margins (profitability), efficient capital allocation and low leverage (solvency and liquidity). The quality factor goes long for great businesses and shorts ‘junk’ companies, i.e. those with lacking cash flows and insolvent/illiquid balance sheets. The factor has well-documented outperformance against the market. Although it has trailed value and momentum, investors might be able to sleep better if they know their portfolio consists of fantastic corporations (as opposed to cheap bargains or stocks that have solid price performance but might be irrationally priced). An example of a quality ETF is iShares Edge MSCI World Quality Factor UCITS (IWQU).
Lastly, the low volatility factor emphasises investments with lower price fluctuations. The goal is not to enhance returns, like with the other factors. Instead, the low vol factor attempts to reduce the volatility of portfolio returns. This could be beneficial for those who cannot withstand large swings in price movement. Curiously enough, there is research suggesting that stocks with lower volatility might outperform those with higher volatility, contradicting the traditional finance theory that higher risk warrants higher return (note that outside of academia, it is not widely agreed that volatility is an actual measure of risk). An example of a low-volatility ETF is iShares Edge MSCI World Minimum Volatility UCITS ETF (MVOL). The following graph shows how this factor, along with the ones previously discussed, performed during the time span of 1976-2016.
Source: MSCI Factor Factsheets: Value
Even though we have focused on equity, factor investing can also be applied to other asset classes (e.g. credit quality, value and momentum) and macroeconomic data (e.g. macro momentum). The approach is similar to the one discussed above.
Factors Will Underperform
Apart from the fact that past returns do not guarantee future returns, there is something crucial to keep in mind when searching for low-cost, tax-efficient factor ETFs: factors will underperform. Think about it: if a specific strategy were to work all the time, then everyone would use it, and the excess returns would quickly disappear. The reason factors work is that there are periods of time in which they actually don’t. Many investors are not willing to systematically follow the model after many years of underperformance, so they are unable to capture the gains when they eventually work. Before pursuing these factors, it's important to consider whether or not the investor has the psychological prowess to stick with below-average returns for extended time periods (think a decade-plus of underperformance).
If you want to know more about market anomalies that could lead to outperformance, check out this article by Yelyzaveta Savchenko on how to beat the market.