Traditional equity research has always thought that most of a portfolio’s returns can be explained by the portfolio’s asset allocation. This has then been taken to mean how much is in specific investment styles—small cap stocks, large cap stocks, growth stocks, value stocks, etc. Newer research now shows that investment results can be explained by certain factors that have outperformed the market over time. A factor is any characteristic shared by a group of stocks that can explain their returns and risk. There are a number of different factors that have historically earned a risk premium—value, size, momentum, quality, low volatility, etc.
Value Factor—Stocks that have low prices compared to their fundamental value
Size Factor–Stocks with smaller market capitilizations
Momentum Factor—Stocks with higher price momentum
Low Volatility Factor–Stocks with lower volatility (Beta)
Quality Factor–Stocks with low debt, stable earnings, and other quality metrics.
There is much speculation about why factor outperformance exists and whether it will persist. The reason some factors tend to outperform can be easily grasped. For example the value factor is most likely a combination of the fact 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. You could also argue that 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 can also probably be boiled down to risk and also smaller stock have more room to grow then larger stocks. Momentum comes down to investor psychology. Investors tend to pile into what ever is going up, creating trends that persist. The quality factor makes sense and companies with strong financials should do better than those with weaker financials. I am not quite sold on the low volatility factor.
For practitioners 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 optimize exposure to factors. 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. If these historical factor risk premiums persist then a well thought out factor based portfolio should outperform style based portfolios.
For practitioners of tactical asset allocation 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. This type of analysis can be either combined or replaced by factor rotation to try to be positioned in the strongest factor. If the academic research is right and stock market performance is driven by factors then this should be a much more powerful approach going forward as it will a purer approach to capturing whatever factor is currently in vogue. Over time, factors have shown a great degree of cyclicality. Each factor has had a least a two year or more period of underperformance vs. market cap weighted indices but they are not completely correlated from an underwater basis. This cyclicality and lack of underwater correlation also lends itself well to a tactical approach.