How to Use Factor Investing to Harvest Excess Portfolio Returns
Article originally posted here by Inspire
by Shane Enete
Factor Madness
I recently lost my March Madness bracket to my wife for the second year in a row. When it comes to filling out my bracket, I use the following factors.
Given that I keep losing to my wife, my factors are not working well. For my wife, her key factors are less scientific.
Because my wife is from the west coast, her “location factor” created a bracket with a large West-coast bias, which worked out well for her this year since most of the final 16 teams were located west of the Mississippi.
Factor Genius
In the same way that there are a variety of different factors that a basketball fan can use to help them fill out a March Madness bracket, there are a variety of different factors that a portfolio manager can use when making stock portfolio decisions.
The foundation factor for a stock investor is the “Market” factor. Exposing your portfolio to this Market factor will allow your portfolio to earn a stock market return that reflects the overall risks of the stock market. As a general guideline, an investor who buys at least 40 companies (i.e., law of large numbers) will harvest the return associated with this Market factor.
Outside of the Market factor, the next most common factor used by portfolio managers is the “Size” factor, which means focusing on smaller companies (i.e., lower market capitalizations) over larger companies. The Size factor (or small-cap tilt) is commonly used by investors because of a seminal 1992 study by Fama and French that showed that small-cap stocks outperformed large-cap stocks by +3% per year from 1927 to 1981.1 Many “efficient market hypothesis” advocates often argue that most investors who outperform the market are simply harvesting this small-cap premium through tilting their portfolio towards small-cap stocks.
A list of common factors that investors use is below.
Research Affiliates performed a study on the performance of these common factors and found that they did provide an additional performance above market returns.2 They also found that these factors performed differently depending on whether the stock market was up or down. For example, from 1963-2018, the Value factor provided a +1.8% return per month during down markets and provided a -0.8% return during up markets. The Size factor was the opposite, it provided a +0.8% return per month during up markets and a -1.6% return per month during down markets.
Not A Slam Dunk
Harvesting factor premiums is not an exact science, and many of the factors that portfolio managers use may not harvest any premiums after all. For example, the Value factor can be defined in many different ways (price-to-earnings or price-to-book? if PE, which earnings value to use? If PB, which book value to use?). A study by 2 Sigma showed how the performance of the Value factor will vary greatly depending on how value is defined.3
Many studies show that tilting a portfolio towards higher momentum stocks (i.e., stocks that have a strong 3-month price performance) would allow it to harvest a momentum premium. However, the Momentum factor suffers greatly from asymmetric returns, which means that, while it performs great during up-markets, if there is a sharp downturn in prices, the actual, experienced momentum premium may not materialize for many investors who do not enter the market at the correct time.4
Factor ETFs
ETF products have commonly incorporated factors into their investment process given that
factors can be incorporated into a portfolio using relatively simple, passive criteria. For example, a Low Beta ETF can easily create a rule to overweight the lowest beta stocks among its investable universe.
The top three factor-based ETFs today:
Vanguard Value ETF ($74 billion AUM; only buy low PE stocks).
Vanguard Growth ETF ($72 billion AUM; only buy high PE stocks).
iShares Russell 1000 Growth ETF ($65 billion AUM; only buy high PE stocks).
Other popular factor-based ETF products include Invesco’s S&P 500 Low Volatility ETF (SPLV), which seeks to take advantage of stocks with lower price swings (i.e., low Beta factor), and iShares’ Edge MSCI USA Momentum Factor ETF (MTUM), which only buys stocks that have gone up recently. There are also many multi-factor ETFs that seek to harvest multiple factors at once (e.g., Invesco FTSE RAFE US 1000 ETF (PRF)).
Many ETF providers equally-weight their portfolios, which is a natural way to take advantage of both the Size and Value factor since equally weighting a portfolio forces the portfolio to own a larger portion of smaller companies than a market-cap weighted portfolio (size factor), and, rebalances consistently towards companies with lower PE ratios (value factor).
ESG and BRI Factor Investing
Many portfolio managers can add non-financial factors, such as Environmental, Social, and Governance (ESG) factors and Biblically Responsible Investing (BRI) factors. ESG factors include the carbon-footprint of a company, employee satisfaction, and diversity of the Board of Directors. BRI factors include whether a company is selling certain products or services that are contrary to Biblical values (e.g., pornography, tobacco, gambling) or using company money to actively change culture away from Biblical values (e.g., funding abortion clinics, LGBTQ activism).
Adding both ESG and BRI factors to a portfolio may help Christians invest in a way that is both fruitful and redemptive for our community. Current studies are mostly positive about the return implications of investing using ESG factors.5 Regarding the return implications of applying BRI factors, not much is currently known. Look for more Inspire white papers on the return implications of BRI factors once more BRI ETF products begin to have 5+ years of performance data starting next year.
Overall, it is considered “smart investing” to incorporate traditional factors, such as the Size and Value factors, into a passive portfolio management process. Investors who have used these factors, over long periods of time, have historically harvested excess returns without taking on the excess risks and fees that may occur from active portfolio management.
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1 Fama, E.F. and K.R. French (1992) The Cross-section of Expected Stock Returns, Journal of Finance, 47, 427-486.
2 Arnott, R., Harvey, C. R., Kalesnik, V., & Linnainmaa, J. (2019). Alice’s adventures in factorland: Three blunders that plague factor investing. The Journal of Portfolio Management, 45(4), 18-36.
3 https://www.twosigma.com/wp-content/uploads/Thematic_Research_Risk_Premia_4_1.pdf
4 Fama, E.F. and K.R. French (1992) The Cross-section of Expected Stock Returns, Journal of Finance, 47, 427-486 (pgs. 16-17).
5 Madhavan, A., Sobczyk, A., & Ang, A. (2021). Toward ESG alpha: Analyzing ESG exposures through a factor lens. Financial Analysts Journal, 77(1), 69-88.