Traditional equity research holds that most of a portfolio's asset allocation explain its returns: Namely, how much is in specific investment styles – small-capitalization stocks, large-cap stocks, growth stocks, value stocks, Treasury bonds, real estate investment trusts, etc. But new thinking shows that other drivers explain returns, ones that go beyond conventional asset classifications.
Newer research now shows that investment results stem from certain factors that have outperformed the market over time. A factor is any characteristic a group of stocks shares that can explain their returns and risk.
There are a number of different factors that have historically determined a risk premium, which is the amount of return over a safe asset, typically U.S. Treasuries. Notable among these factors are:
Value. Stocks that have low prices compared to their fundamental value – that is what they are worth given their earnings history and other attributes.
Size. Stocks with smaller market capitalizations.
Momentum. Those with higher price momentum, meaning they have been moving upward and likely will continue to do so.
Low Volatility. Ones that don’t gyrate as much as the overall market. This uses a metric called beta, which measures how the market’s moves tend to affect an individual security.
Quality. Stocks with low debt, stable earnings and other quality metrics.
Much speculation turns on why factor outperformance exists and whether it will persist. The reason some factors tend to outperform is easily grasped.
For example, the value factor is based on the notion that, if you buy something at a lower price and hold onto it for a long time, then it should do better then something you buy at a high price. To be sure, value stocks are riskier than growth stocks, since they have a more uncertain future and markets compensate investors for taking more risk.
The size factor? Smaller stocks have more room to grow then larger stocks, although small companies usually suffer more in recessions because they are more vulnerable economically.
Momentum comes down to investor psychology. Investors tend to pile into what ever is going up, creating trends that persist. The quality factor rests on the commonsensical idea that companies with strong financials should do better than those with weaker ones.
I am not quite sold on the low volatility factor. While stocks that don’t rise or fall as much as the market seem to possess the virtue of steadiness, that doesn’t suggest a lot of upside for investors. They suffer less harm in downturns, but don’t benefit as much from the rallies. And equities tend to rise more than fall over time.
For investors who still follow a traditional asset allocation approach, this new research presents a way to take a flawed investment philosophy and make it less flawed. Instead of trying to optimize portfolios by investment styles, you could increase factor analysis.
Investment styles will still have factor exposure, but it will not be pure. For example, a market cap weighted index of value stocks will still hold some stocks that are more blends between value and growth.
For practitioners of tactical asset allocation – which seeks to allocate assets according to market trends and exploit inefficiencies, among other dynamic moves – factor investing provides another powerful tool.
Historically, many tactical strategies have focused on style or sector rotation as a way to be positioned in the strongest style or sector. You can combine or replace this type of analysis with factor rotation, where the strongest factor determines how to shift your holdings.
Over time, factors have shown a great degree of cyclicality. Each factor has at least a two-year period of underperformance, versus market cap weighted indexes. But they are not completely correlated during a downturn, known as underwater correlation.
But if the academic research is right and factors drive stock market performance, then this factors-oriented strategy should do well, as it favors whatever factor is currently in vogue.
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Nothing in this article should be interpreted to state or imply that past results are an indication of future performance. Please consult your tax or investment advisor before making any investment decisions.
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