The Factors Behind Factor-based Investing
Factor-based investing, or smart beta funds, track indexes that are constructed around one or more factors. There are five common factors that have historically outperformed the market or reduced a portfolio's level of risk over the long term. While some investors may tout complex definitions, most are not robust enough to explain return once the following five factors are accounted for. The factors to seek exposure to are:
Value: Value stocks are those that trade at a low price relative to their fundamentals, such as earnings or sales. They have been shown to outperform the broader market indices over the long term, potentially due to investors’ behavioural biases and the reward for taking additional risk/providing liquidity in a stressed environment.
Quality: This factor focuses on companies with low debt, stable earnings and high profitability. Higher quality companies seem to be rewarded with higher returns over the longer term because they have been shown to be better at deploying capital and generating wealth than the broader market.2 This is particularly true in times of market stress when a company’s ability to service debt and provide visibility on earnings becomes more important.
Size: Small-capitalisation stocks have tended to outperform their large-capitalisation peers over time.3 There are a number of potential drivers for the long term strong performance of smaller capitalisation securities. Their smaller size means they are generally considered to be riskier (less diversified, less covered by analysts and less well known), which has two implications. Firstly, investing in small capitalisation companies requires a well diversified portfolio to mitigate stock specific risk; secondly, the market demands a higher expected rate of return for holding them – the so-called “small capitalisation premium”.
Low Volatility: The long term historic out performance of low volatility strategies may be explained by the theory that some investors overlook “boring” low volatility stocks in favour of “glamorous” ones and, in the process, miss out on the consistent returns low volatility stocks can offer. The implication of this is that the risk/return relationship holds between asset classes, but not necessarily within an asset class.
Momentum: Empirical evidence shows stocks thathave done well recently may have greater potential of doing well in the near term than the broader market, and stocks that have performed poorly continue to perform poorly.4 Portfolios which consider momentum can benefit from the momentum in stocks over the shorter term.
Other Smart Beta Factors to Consider
Different firms recognise slightly different factor lists, but the factors above appear in most published lists.
In addition, Yield may be a smart beta factor to consider. Over the long term, stocks with higher dividends tend to perform better than stocks with lower yields, possibly due to the Value or Quality characteristics of yield.5
And although we don’t consider ESG to strictly be a smart beta factor, we do see it increasingly being used alongside other factors as a powerful complement for risk reduction. There have been over 2,200 studies conducted on the relationship between ESG and corporate financial performance, and over 90% of the empirical studies have shown better risk management and diversification at the portfolio level, without sacrificing performance.6