Note: This article is courtesy of Iris.xyz
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 research1 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.[related_stories]
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.