Elements of Performance
Factors are fundamental drivers of risk and returns.
A factor is any characteristic that helps explain the long-term risk and return performance of an asset class. Factor investing is not new; it has long been used in quantitative investment strategies. Factor investing seeks to capture higher risk adjusted returns via systematic exposure to stock characteristics. Over the years, both the academic world and the investment industry have identified 6 individual factors that have historically delivered out-performance relative to the broad stock market.
How Are Factors Screened?
- Low Volatility: The inverse of volatility, a measure of the risk of an asset measured by the standard deviation of returns over a particular interval of time.
- Dividend Yield: A measure of a company’s dividend relative to its underlying price.
- Quality: A measure of balance sheet strength and earnings stability.
- Momentum: A measure of recent strength in stock price behavior (stocks that had positive excess returns in the recent past).
- Value: A measure of how inexpensive a stock is relative to its fundamentals.
- Low Size: A measure of the market capitalization of a company relative to companies in a given universe of stocks.
Why Construct A Portfolio Using Multiple Factors?
Research has shown that investing in a combination of factors historically has enhanced long-term returns relative to traditional market cap-weighted index fund portfolios. Also, tilting towards factors can improve risk-adjusted returns without reducing liquidity, investability, and diversification.
Factor performance changes over a business cycle. We obtain more diversified outcomes when we construct a portfolio harnessing different factors.
- Minimum volatility, yield and quality are considered “defensive” factors and tend to benefit during periods of economic contractions.
- Momentum is considered a “persistence” factor and tends to benefit during continued trends in markets.
- Value and size are considered “pro-cyclical” factors and tend to benefit during economic expansion.
Review factor performance from January 1977 through December 2019.