By Beaumont Capital Management

In the spectrum of investing from passive (index based) to active management there are no shortage of considerations. Passive tends to be cheaper and should deliver returns very close to the index it tracks, which is great in up markets, less so in down markets. Active tends to be more expensive and relies on the skill of the portfolio manager(s) to deliver desirable results.

Factor investing is a blended approach which may be best characterized by the popularly used phrase ‘smart beta’. Factor investing refers to a passive, rules-based approach where the burden of management has been shifted to a researched process attempting to provide value (perhaps greater return and/or with less risk). For example, the S&P 500® Index, which is a market capitalization (cap) weighted index, can be purchased in an ETF tracking this index at a very low cost and provides nearly identical performance to the S&P 500 itself. Alternatively, one can purchase an equal-weighted version of the S&P 500 index as an ETF which delivers a different return stream that may be beneficial to an investor when smaller cap stocks outperform. By simply changing market cap to equal weight, a ‘smart beta’ investment has been created. With the proliferation of so-called smart beta approaches it can be overwhelming to even begin exploring the vastness of these methodologies. The purpose of this paper is to explore a subset of the smart beta universe that specifically focuses on factor investing.

What is a factor?

A factor can be thought of as any characteristic relating a group of securities that is important in explaining their return and risk…one view is that factor returns are compensation for bearing systematic risk…the market can be viewed as the first and most important equity factor…researchers generally look for factors that are persistent over time and have strong explanatory power over a broad range of stocks.”

How many factors are there?

Factor research began in earnest with the capital asset pricing model (CAPM) of Treynor (1961) and continued with Sharpe (1964), Lintner (1965), and Mossin (1966). The model proposes that the return on an investment is a function of its sensitivity to market risk, so that an investment with a high exposure to market risk, or a high beta, should earn higher returns. The CAPM is a single-factor framework whereby the only risk that should be rewarded is market risk.

Many others including Fama and French have built upon this initial work and the notion that certain characteristics found in a group of securities can explain the corresponding return and risk of the securities.

Not surprisingly, academics and practitioners alike have attempted to explore the possibility of even larger numbers of factors. One recent study examined 316 factors from over 400 research papers only to find that many do not pass a test of statistical significance.

Most research on factor investing has determined six equity factors of significance: value, size, momentum, low volatility, dividend yield, and quality. The exact definition of each is not universal, but at a high level they are generally similar in design. The following table from MSCI summarizes this:

how-many-factors-are-there

A common question and ongoing debate is whether factor returns can persist. If there is support both from a logic and research basis about a persistent, desirable return simply by investing in a group of stocks with similar characteristics, then why wouldn’t everyone invest in these stocks? Perhaps they do. After all, if everyone is aware of a trade that makes you richer, then in theory everyone will attempt to exploit it, eventually negating its existence. It is therefore reasonable to assume that like all other facets of investing, there is the risk of losing principal. Examining long-short factor indexes that attempt to isolate the factor return shows indeed that factors don’t always pay you for holding them. In addition, there are many economic and market forces that supersede or overwhelm a factor’s performance over short periods of time. Therefore, an investment in a factor may need to be held long-term to show its potential value-add or conversely, bought and sold when the factor opportunities are greatest. As the chart below shows, factors have good years and bad. This creates opportunity!Are factor returns persistent?

factors-excess-returns-over-msci-usaHow to allocate to factors?

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