Factor investing is about using style factors such as value, quality, momentum or low risk to tilt portfolios in favour of cheaper (value) outperforming (momentum) stocks or corporate bonds from the most profitable and better managed (quality), less risky companies (low risk). Such an approach is based on strong academic and empirical evidence that these stocks and corporate bonds should deliver the highest risk-adjusted returns. But the construction of a portfolio can make a huge difference in terms of performance, to the extent that all expected outperformance may be wiped out by poorly constructed, factor-tilted portfolios. Why? Because style factors are not the only factors that explain stock and corporate bond returns. Making sure that other factors do not pollute your portfolio can make all the difference. Here is a summary of the some of the key factors that explain stock and corporate bond returns and a brief explanation of why this is the case, along with an illustration of how costly poorly-constructed equity and corporate bond factor-based portfolios can be.
Equities: The market factor
Several types of factors are known to explain stock returns. The first and most important is the market factor itself, which explains why the stock prices of most companies tend to move in the same direction. It reflects the fact that businesses are exposed to the overall economy and thus, not surprisingly, stock returns are sensitive to shocks in the economy. When investing in equities, investors expect to earn the equity risk premium as compensation for being exposed to this risk.
Equities; sectors, regions and size
However, the economy is divided into sectors in which businesses provide similar or related products or services and tend to have common operating characteristics. On account of the different nature of their businesses, the relative performance of stocks in different sectors tends to rotate as the overall economy shifts from one stage of the business cycle to the next. For this reason, sectors are a type of factor that explains additional differences in stock returns.
Similarly, in international portfolios, companies operating in different regions tend to be exposed to different regulatory environments and other specific regional constraints, which is why regions are also a type of factor that explain differences in stock returns.
Equities: style factors
As mentioned at the outset, there is another type of factor that explains additional differences in stock returns beyond those accounted for by exposure to the market factor, to sector, region and size, namely style factors.
Style factors include value, quality, low risk and momentum. They are of particular interest to investors because they tend to predict differences in future stock returns. Research over long periods has demonstrated that stocks with higher future returns tend to be those of companies trading at cheaper valuations (value), that are more profitable and better managed (quality), less volatile (low risk) and that have been outperforming (momentum). A substantial body of research relates the observed empirical outperformance of value, quality, low risk and momentum stocks to investors’ behavioural biases.
Factor investing is about taking advantage of style factors to tilt portfolios in favour of value, quality, low risk and momentum stocks. But such an approach can only be part of the story because, as described above, other factors play a role in determining stock returns. If, inadvertently, an investment in a factortilted portfolio leaves us with exposures to sectors, regions, size or market factors, then the returns to the portfolio will also be affected by those exposures. It is therefore critcally important to make sure that the factor-tilted portfolio and the benchmark index have similar exposures to sectors, regions, size and to the market factor. Otherwise, any outperformance from picking the right stocks based on style factors may be cancelled out by the consequences of these other factor exposures.
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