Factor Investing: Part 1 THIS MESSAGE IS SENT SOLELY TO MEMBERS OF FSINSIGHT Key Takeaways:
IntroductionThis will be the first in a series of regular research notes commenting on the performance and general landscape for factor investors. Quant investors, who generally are aware of these issues, can use this first article to get acquainted with value and quality as lenses through which to analyze equities. Fundamental investors can use the article to better understand the risks inherent in their portfolios from the point of view of factor investing. For this version of the factor monitor, we will use publicly available indices and ETFs to track factor performance. As we continue to build out the Fundstrat quantitative platform, we will include proprietary versions of these factors, and comment on the performance of the Fundstrat factors compared to their publicly available counterparts. What it means: Think of factors as different dimensions of risk to analyze your portfolio. In the same way that it is very hard to fly a plane without instruments giving you altitude, pitch, and roll it is also very hard to understand the effects various risks and shifts in market sentiment will have on your portfolio if sensitivity to risks are not viewed through multiple lenses, or factors. The earliest quant could be considered the Father of Value Investing and author of The Intelligent Investor Benjamin Graham. The next major stride in the discipline occurred when Harry Markowitz published his revolutionary paper Portfolio Selection in 1952. General Factor CommentaryOur discussion focuses on five well-known factors:
This first report will cover only value and quality. The second report will cover momentum, low volatility, and size (small/medium/large cap). The third and final report in this series will explain how to construct a portfolio using the factors introduced in the first two of the series. These factors have been explored substantially in academic circles, and have been known to quant investors for decades. For the purposes of these analyses, we consider factor premia, or the excess return of a factor relative to an appropriate benchmark. Absolute factor returns are driven primarily by the overall return of the market, so to separate out the premium of an individual factor, one must consider the excess return. [1] Fig. 1 below shows the performance of these factors over the past 3 and 12 months. [1] We specifically consider the market-relative return of each factor in our analysis. Another approach to separate out factor-specific return is to compute the beta-adjusted return of the factor. Using excess returns assumes all factors have a beta of one to the market, and produces factor premia which can be implemented as dollar-neutral portfolios. What it means: Factor premia refers to the premium of one factor versus a benchmark, like the S&P 500. For example, you may hear a lot about continuous shifts between growth and value. Value stocks are those that have a price near or below some measurement of intrinsic value or may enjoy a deep discount compared to peers. Fig. 1 Recent performance of factors Individual Factor CommentaryFactor 1: Value FactorThe value factor (which we define as the spread between the S&P 500 Value ($IVE) and S&P 500 Growth ($IVW) indices) has produced little in the way of excess return over the past 25 years (see Fig. 2). Deterioration in the returns to value has accelerated over the past 5 years, with value underperforming by nearly 40% since the start of 2020. Fig. 2 – Value Factor Cumulative Performance This level of value underperformance only occurred one other time in the history studied here – during the tech bubble of the late 1990s. Even if we exclude the pronounced underperformance of value during these periods, the factor has generally seen a slow bleed down in performance for the past 15 years. Myriad explanations have been put forth for the underperformance of value (i.e. flattening of the yield curve, suppression of rates, a premium placed on high-growth companies in a low-growth world) but the fact remains that value has experienced a continued downturn in performance with occasional large relative losses. Recently, value’s underperformance has continued, as it has underperformed by 3.3% during the third quarter of 2021. What it means: We described the difference between value and growth and how preconceived notions can affect how investors group stocks into those categories. We want to give you an example of one stock for each factor category so you can look into the characteristics that place it there. Marathon Oil ($MRO) is a great example of a stock that currently scores high across value factors. Of course, MRO’s scores (like any stock) can change with time. Factor 2: Quality FactorThe quality factor (measured as the spread between the S&P 500 Quality index[2] ($SPHQ) and the S&P 500 index ($SPY)) was essentially flat over the past quarter and has lost a little over 2% over the past year. Over the past decade, its performance has been mainly flat (see Fig. 3). Quality experienced a rapid run-up in performance following the tech bubble, and then continued to churn higher over the first decade of the 2000s, but has produced little return over the past decade. As can be seen from the chart, quality tends to do best in and around periods of economic upheaval. [2] The S&P 500 Quality Index includes stocks that have high ROE, low financial leverage, and low accruals. More information can be found here. Fig. 3 – Quality Factor Performance Unlike value, there is no “consensus” definition of quality. The index we use here defines high-quality stocks as having a high return-on-equity, low financial leverage, and low earnings accruals (i.e. the difference between earnings and cash flows). Other definitions for quality include stocks with low earnings volatility. We will explore the definition of quality in a future research note. What it means: Wal Mart ($WMT) is an example of a stock that currently scores high on the quality factor. Since there is no consensus on the investment definition of quality, using another factor like low earnings volatility might generate different names. Generally, quality will capture established companies that have a demonstrated track record of consistent earnings relative to peers and other stocks in our analyzed universe. |
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