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ACM Journal - Investment Management
9 Apr

What Are Factors? – Q1 2020 Newsletter

Factor-based investing, or what has become known as “Smart Beta” is a strategy that has been prevalent in academic and larger institutional realms for many years. However, it is just recently trickling down to the investment advisor and retail investor world.

You may have seen ads for these types of funds in the Wall Street Journal or on CNBC. It seems lately that every large investment firm is racing to issue funds that capitalize on investment factors. We have been implementing this approach since the inception of our firm, but it continues to evolve.

So, what are factors? In general terms, they are stock market characteristics that tend to outperform the overall stock market over many years. For example, “value” stocks have generally provided stronger returns than “growth” stocks over longer periods. There is no universally agreed upon reason as to why this is the case, but it is generally accepted that value stocks have and should continue to generate outsized returns.

There have been dozens of factors identified in the academic literature, but many of these have been discredited over time. The four widely accepted factors that have been persistent include “value”, “momentum”, “quality”, and “low volatility”.

The other well-known factor this is regularly discussed is “size”. That is smaller-capitalization stocks have historically generated larger returns than large-capitalization stocks.

This has been examined over many decades, and the academic consensus is now that size is really not a factor for a number of different reasons. An interesting corollary is that while small-cap stocks may not be a proper factor, the other factors express themselves better in the small-cap part of the stock market, resulting in higher returns in that market segment.

While factor-based investing should provide stronger returns than the overall stock market, that is not always the case. Unfortunately, there is no investment approach that can always outperform, but factor investing does have some compelling return characteristics.

The various factors also move in different patterns from one another, which increases overall portfolio diversification. Accordingly, we have been able to build an approach that reaches for higher returns, but without adding too much additional risk.

This diversified factor methodology helps mitigate the odds of underperforming the overall stock market but cannot eliminate it completely over shorter periods. For example, while momentum stocks have performed well over the past several years, their strong performance has been more than offset by weakness in value stocks.

Even though value stocks are expected to outperform the overall stock market over time, there have been fairly long periods when that has not been the case. We are in one now. If you were only invested in value stocks, that could have a significant adverse impact to your investments. But, diversifying across factors can reduce the impact of any one factor not performing well.

We have been using value and momentum stocks for many years. We added a low-volatility fund a while back and are now adding a quality fund as well. We are also expanding our factor approach to the small-cap, international, and emerging markets segments of the portfolio. After much research, we are confident this tips the odds of stronger performance in our favor without increasing risk, costs, or tax liability in any significant way.
We will be reporting portfolio holdings and performance going forward in more of a factor-specific manner. So, you likely will be hearing more about this topic in the future.

There are no agreed-upon definitions for factors, but here are some common guidelines:
ValueValue stocks are those that trade at a deep discount to their intrinsic value. That generally means they have low price-to-earnings ratios, often in the bottom 30% of all stocks. Some stocks have low valuations for a reason, often financial distress, and they go out of business. However, historically enough value stocks have been able to survive and improve their fortunes that a diversified portfolio of these stocks has performed quite well.
MomentumMomentum simply means that stocks going up tend to continue going up, and those declining tend to continue declining. The time period is important, as short-term momentum tends to be statistical noise, and very long-term momentum tends to eventually reverse. However, capturing stocks with strong 12-18 month price momentum has been rewarding in the past.
Low VolatiltyIronically, stocks with lower volatility, or risk, have outperformed stocks with higher volatility over time. While risk and return are related, the common wisdom is that if you take more risk, you get more return. However, there are subtle differences in types of risk, and volatility is not always rewarded with stronger performance. This factor therefore gives hope of “having your cake and eating it too”.
QualityStocks with higher quality, or those with stronger balance sheets and consistent earnings histories have historically generated larger returns than weaker companies

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