What are factors?
Over the last several years, investors have been inundated with attempts to re-brand factor investing – “smart beta,” “strategic beta,” “engineered equity,” “beta plus,” etc. While the list of marketing-driven buzzwords continues to expand, they are all largely synonymous with factor investing. They each refer to investment strategies focused on systematically gaining exposure to stocks (or bonds, currencies, commodities, etc.) with one or more characteristics that have been empirically shown to drive positive active returns – that is, returns over and above the cap-weighted market index.
The first, and most well-known factor discussed in academic literature is the market factor, which is generally defined as the excess return of the market over the risk-free rate. By increasing exposure to the market factor relative to Treasury bills, (i.e. taking additional, undiversifiable market risk), an investor is compensated with a higher expected return over an extended time horizon. Investors accept the risk of underperforming in the short run for the expectation of outperforming over the long run.
Unfortunately, in practice, exposure to the market factor alone does not fully explain the differences in returns between portfolios. To better understand what characteristics drive performance differentials between portfolios, academics began searching for and finding “pricing anomalies,” otherwise known as factors.
In addition to the market factor, the primary equity factors we focus on are:
- Size – small companies have tended to outperform large companies;
- Value – cheaper companies (in terms of a high book value or earnings relative to market value) have tended to outperform expensive companies;
- Momentum – companies that have recently performed well have tended to outperform companies that have recently performed poorly; and
- Quality – companies with high profit margins and strong balance sheets have tended to outperform companies with lower profits and weaker balance sheets.
Why do these factors add value? If they are widely known, why should we expect them to continue to add value?
The answer to these questions can typically be described as either “risk-based” or “behavioral” in nature. Risk-based explanations assert that factors have rewarded investors with excess returns because stocks that exhibit these characteristics are inherently riskier. Therefore, investors require a risk premium in return for owning them. For example, small companies tend to have smaller capital bases, higher leverage, increased default risk, etc. Value companies, on average, tend to be more exposed to the business cycle, carry more fixed assets, be more highly levered and tend to have a higher risk of distress than growth companies. Given these increased risks, it makes sense that investors would demand, on average, a risk premium (higher expected return) to invest in smaller companies over larger companies or value stocks over growth stocks.
Behavioral explanations assert that factor risk premiums do not exist solely due to increased risk, but rather due to a combination of risk factors and investor biases that hinder the market from correctly pricing these anomalies. For example, the momentum effect is typically supported by behavioral explanations. One version, put forth by Toby Moskowitz, asserts that information travels slowly into prices1. He argues that prices do not immediately adjust to news but tend to drift upwards (or downwards) as the market processes the good (or bad) news – this is underreaction. Somewhat counterintuitively, Moskowitz also finds that overreaction also plays a part as investors chase the newly created trend and can push prices farther from equilibrium, introducing a short to intermediate term momentum effect. Quality is also likely a behavioral anomaly; after all, who would rationally require high quality stocks to generate a risk premium over low quality stocks? Research by Ryan Liu suggests it is related to investor expectations2. Investors are willing to make contrarian bets on low quality companies at the expense of high quality companies. This behavior has the effect of increasing the prices (and therefore driving down expected returns) of low quality firms at the expense of high quality firms, while also increasing expected returns of high quality companies.
All five factors mentioned have risk-based or behavioral explanations that support each factor’s existence, and often more than one of each. What is important to know and remember is that no one can be certain which, if any, hypothesis is correct about why a certain factor works or has worked. We cannot prove why a factor works, but by utilizing a rigorous and analytical framework we may be able to assess whether a factor is real and whether it can be expected to continue to exist in the future.
Researchers and practitioners Larry Swedroe and Andrew Berkin propose such a framework below, requiring that any factor pass the following five-part test3. They stipulate that for an anomaly to be considered a true factor and not just noise, it must be:
- Persistent – it must generate excess returns over long periods of time and across market regimes
- Pervasive – it must be present across different asset classes and geographies
- Robust – it must continue to “work” despite tweaking the definition of the factor
- Investable – the excess returns must be large enough to still add value after frictions such as trading costs are accounted for
- Intuitive – it must have a logical underpinning (risk-based or behavioral) that supports a risk premium being associated with it and that also supports its efficacy in the future
So, is Factor Investing Easy?
Unfortunately, no. Even the factors with the strongest historical returns have the potential to significantly trail the market over long stretches – think Value stocks during the tech boom in the late 1990’s. Even more recently, Value stocks were trounced by the broad market in 2015 and early 2016. Experiencing a massive drawdown or trailing an index by double digits is painful – but potential for such short-term pain is also why factors tend to add value over long time horizons. If something works all the time, there would be no risk premium associated with it. Thus, patience is a prerequisite for harvesting a factor’s excess returns. It is also why diversifying across factors is an important component of a sensible factor strategy. Value and Momentum, for example, have historically displayed a low correlation to each other. When Value tends to be out of favor, Momentum tends to be in favor and can offset losses in the Value portfolio, and vice versa. Similarly, Quality can augment Value and Size, helping to screen out the lowest quality companies most likely to be “value traps.” By diversifying across factors, we can dampen the volatility of the portfolio while reducing the risk of any one factor having an outsized impact on the portfolio.
Factor investing is no free lunch. It requires conviction, patience, discipline, the willingness to be out of step with the broad market, and a long-time horizon. Note that these are many of the same characteristics required to be successful in virtually every other area of investing, as well.
- Factors are characteristics of stocks or stock portfolios that have been shown to drive positive excess returns over time
- Factor investing seeks to harvest excess returns by owning stocks that display these characteristics and by avoiding stocks that display the opposite characteristics
- Factor risk premiums exist due to some combination of increased risk, behavioral biases, or structural inefficiencies in the market
- We can avoid mistaking randomness for a factor that deserves a risk premium by making sure the factors we utilize are persistent, pervasive, robust, investable, and intuitive
- Factor investing is hard; it does not work all the time and individual factors can sometimes trail the broad market significantly. It requires conviction and patience.
- Factor diversification can reduce volatility but not eliminate it.
- Moskowitz, Tobias J., “Explanations for the Momentum Premium,” AQR Capital Management White Paper, 2010
- Liu, Ryan, “Profitability Premium: Risk or Mispricing?” November 2015. https://pdfs.semanticscholar.org/94f3/bb0d05a8fe349d3ca378bbe52e1f9ac72831.pdf
- Berkin, Andrew L. and Larry E. Swedroe. Your Complete Guide to Factor-Based Investing. Saint Louis: BAM Alliance Press, 2016. Print.