Factor-based investing: Targeting the real drivers of return
Factor-based investing generally refers to a category of rules-based approaches to investing. It seeks to capture a handful of factors, such as the size of a company or value characteristics, which have been shown to drive returns.
Understanding each of the factors can help to choose the right mix of exposures according to an investor’s risk tolerance and investment goals.
Factor-based investing – or smart beta – generally refers to a category of rules-based approaches to investing. These strategies seek to capture specific factors, or investment characteristics, such as the size of a company, Volatility, Valuation or Quality profiles. Factor-based investing can help investors achieve returns in excess of more straight forward market capitalisation weighted indices: research has shown that between 50% and 80% of a portfolio’s excess return can be attributed to exposure to specific factors, such as low volatility or size.1
Once factors are understood, factor-based investing is a straightforward, systematic and cost-effective approach to generating returns.
Although factor-based investing strategies may be attracting much attention in recent years, the underlying investment philosophy has been around for several decades. It was first introduced through the capital asset pricing model (CAPM) in the 1960s, which suggested that a single factor – market exposure - helped to explain a stock’s performance relative to its index. Essentially, this argued for market capitalisation weighting as a good starting point for investment decisions.
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
Combining Multiple Factors
Understanding each of the factors can help to choose the right mix of investments according to an investor’s risk tolerance and investment goals. It is also important to note each factor performs differently in different market conditions. Quality and low volatility strategies tend to outperform in market downturns, while value strategies usually deliver strongest returns in risk-seeking environments.
Because different factors may perform well cycles.at different times, investors may want to consider investments that diversify across multiple factor strategies. A multi-factor investment aims to target improved performance characteristics. Combining, for example, volatility, value and quality factors may offset the cyclicality of single-factor performance, and achieve smoother returns over different business cycles.7
2“The cross-section of expected stock returns,” Fama, E. & French, K., Journal of Finance, June 1992, 47, 427–465; Fama, E., & French, K., “Common risk factors in the returns on stocks and bonds,” Journal of Financial Economics, Volume 33, issue1, as of 6/1992, 3–56.
3“Low Risk Stocks Outperform within All Observable Markets of the World,” Baker, Nardin and Haugen, Robert A., as of 4/27/2012.
4“Stock Returns and Dividend Yields: Some More Evidence,” Blume, M.E., The Review of Economics and Statistics, 1980, 62 (4) 567–577
5See, for example, Khan, Mozaffar, Sarafeim, George and Yoon, Aaron S. “Corporate Sustainability: First Evidence on Materiality.” The Accounting Review, Volume 91, 2016 and Clark, Cordon, Feiner, Andreas & Views, Michael. “From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance.” Arabesque Asset Management and Oxford University 2015.
6See, for example, Khan, Mozaffar, Sarafeim, George and Yoon, Aaron S. “Corporate Sustainability: First Evidence on Materiality.” The Accounting Review, Volume 91, 2016 and Clark, Cordon, Feiner, Andreas & Views, Michael. “From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance.” Arabesque Asset Management and Oxford University 2015.
7Bender, J., R. Briand, D. Melas, R. Subramanian and M. Subramanian. 2013.Deploying Multi-Factor Index Allocations in Institutional Portfolios.
This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. All information is from SSGA unless otherwise noted and has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. A Smart Beta strategy does not seek to replicate the performance of a specified cap-weighted index and as such may underperform such an index. The factors to which a Smart Beta strategy seeks to deliver exposure may themselves undergo cyclical performance. As such, a Smart Beta strategy may underperform the market or other Smart Beta strategies exposed to similar or other targeted factors. In fact, we believe that factor premia accrue over the long term (5-10 years), and investors must keep that long time horizon in mind when investing. The Fund employs a value style of investing that emphasizes undervalued companies with characteristics for improved valuations, which may never improve and may actually have lower returns than other styles of investing or the overall stock market. Investments in small-sized companies may involve greater risks than in those of larger, better known companies. Past performance is not a guarantee of future results.
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