Written by: Dave Gedeon / Head of Research & Development, Nasdaq Global Indexes
Although recent interest in factor-based investing would lead one to believe that this is a new-fangled trend, the truth is factor-based investing has existed for decades. In fact, it has been a key component in the stock selection framework of active managers for years. At its core, factor-based investing involves identifying characteristics in a group of securities that help explain its risk/return profile. For example, value investing is a factor-based strategy that focuses on a subset of stocks that displays attractive valuation metrics relative to the general market. Thanks to smart beta, investors today can gain exposure to this factor and a wide array of others with ease, in a transparent and low cost vehicle.
These well-known investment factors have become the guiding philosophy behind a large swath of smart beta products. Third party research 1 indicates that these factors deliver results with returns in excess of market capitalization strategies over the long run. Each individual factor may not outperform every year, but over time the factors can provide a superior risk/return profile to the broad market. Moreover, factor strategies tend to display low correlation with each other as each is driven by a different set of risk factors.
There are many factors at an investor’s disposal, and the explanations of investment returns are limitless. The five factors of focus in this piece are Volatility, Momentum, Quality , Size and Value. Perhaps more important than the explanation of the factors is an investor’s ability to select a factor that is favorable in certain market environments or even to combine several factors into a single portfolio.
Low volatility. The concept of low volatility or low beta is simple yet powerful. A portfolio comprised of stocks with lower volatility when compared to its benchmark can produce higher risk-adjusted returns and generally produce a superior information ratio over all periods. This factor becomes increasingly potent in times of market strife such as witnessed in 2008.
Momentum. This factor is generally viewed as the opposite of volatility. A relative strength or momentum strategy picks stocks that have historically outperformed the market as studies show that this outperformance is likely to continue in the short to medium term. Much research has been done on this factor, and it is important to be able to harness momentum in the right market environment.
Quality. The notion of quality has gained steam during the economic recovery and U.S. equity bull market since 2009. Quality focuses on factors such as equity return, leverage ratio, and earnings variability. This factor can exhibit strong returns over time as the companies that fit this mold have consistent track records.
Value. One of the originally identified smart beta factors is value which seeks to identify the disconnect between a company’s stock price and its intrinsic value. Ratios such as price to earnings and price-to-book are used to take advantage of this disconnect.
Size. Smaller capitalization stocks tend to outperform over the long run. The key notion here is that smaller capitalization stocks within a benchmark tend to outperform the larger capitalization stocks within that same benchmark.
Portfolios of Factor Exposures
The interest in factor exposures has provided investors with the opportunity to not only focus on asset class diversification, but to also build a diversified portfolio of factor exposures. For example, for more defensive positioning, managers can create a simple blend of the three least volatile factors: low volatility, quality and value. A less risk-averse outlook can create a portfolio in which all five factors are equally weighted. If an investor is particularly aggressive, the blend would emphasize the two highest volatility factors: momentum and size.
Of course the question asked is “How do I utilize each factor in a consistent manner?” As recent articles have pointed out, all of these factors have exhibited outperformance over the market during the past 20 years. Though to realize that outperformance an investor would have to ride through the ups and downs of the long market cycle. The easiest answer to the question is to throw the factors into a Nutribullet and blend away.
The Best Recipe for Blending Factors
Multi-factor solutions have been created lately to blend the benefits of each factor into a single investment strategy. The concept is pretty simple: select the companies that have the highest factor attribution of the main factors and blend them together into a single index. While often these multi-factor strategies can outperform the benchmark, there is still the risk that the index is not properly defining the timing and best usage of an individual factor. The multi-factor blend is a strategic asset allocation, a basic catchall strategy that looks great on paper. We’ve moved to a tactical world so strategies must follow suit.
Our favored approach, instead, is to take advantage of the most powerful factor, momentum, and apply that factor as the selection overlay to the other factors: size, volatility, value and growth. The goal is to utilize the momentum signal as the basis for deciding which factor is in favor in the market. That selected factor will then be the single exposure for the index as long as the factor is in favor. The result is a “momentum + factor model” that will take advantage of momentum plus the most favored factor.
This methodology is rooted in an objective relative strength ranking of the factors' price performance each month which results in rebalancing each month. By rotating between these factors, the index will focus on the favored factor and take advantage of particular market trends. Examples are aplenty, whether it is Low Volatility exposure from July 2008 to March 2009 or Pure Value exposure from August 2012 to December 2013 resulting in a 60% gain in the underlying strategy value.
When looking to gain exposure to factors it is important to know how to combine them together. A blended approach is a simple solution but does not fully capture the benefit of relative strength selecting the factors.
Utilizing a relative strength overlay on powerful single factors drastically improves return and lowers volatility yielding a strong information ratio. This investment thesis also solves the problem of when to be invested and for how long. Taking the guesswork out of factors prevents riding the ups and downs of each known factor and instead pivots the exposure to the right factor at the right time, for the right amount of time.
All values back-tested, exclude dividends and are rebalanced at each month-end. All data between 12/31/2002 and 3/8/2016.
Smart beta can be described as factor-based investing, a form of investing that active managers have employed for decades. Five of these factors are Momentum, Volatility, Quality, Size, and Value. Multi-factor approaches to smart beta include a combination of a number of factors in a one-ticker solution. As great as multi-factor products can be, tactical rotation products (products that can rotate in or out of products in a rules-based, transparent fashion) tend to outperform given their ability to adapt to changing market dynamics. At Nasdaq, we believe highly in the momentum factor. Over the long term, momentum with an additional factor is one form of factor rotation that has performed quite impressively over the last 13 years. Tactical factor rotation is the newest smart beta trend, one which we expect to perpetuate for years to come.
1Fama, Eugene F. and Kenneth R. French (1992), “The Cross-Section of Expected Stock Returns,” Journal of Finance 47 Rosenberg, Barr, Kenneth Reid, and Ronald Lanstein (1985), “Persuasive evidence of market inefficiency,” Journal of Portfolio Management, Vol. 11, No. 3, Carhart, M. (1997), “On Persistence in Mutual Fund Performance,” the Journal of Finance 52(1),