Factor Focus: Momentum. Research Insight — Riding on Momentum. Read the blog. Commonly grouped as tech stocks or growth companies, it seems reasonable to assume they share many similar characteristics. However, when examined through the lens of performance-driving factors, their characteristics are far from homogeneous. Value and momentum factors typically move in opposite directions — that is, when one outperforms the market, the other usually underperforms.
However, as both factors have underperformed the market, several publications are beginning to question whether this change in market behavior is impairing quantitative strategies. MSCI factor indexes. The Future of Factor Investing. Social Sharing. Extended Viewer. The Future of Factor Investing Jan 7, Read More. Machine Learning Factors Capturing Non Linearities in Linear Factor Models The linear factor model has been a workhorse for understanding portfolio exposures, risk and performance for many years.
Learn More. A Consumer Sentiment Factor from Web Content The explosion in alternative data has been a blessing and a curse to investment managers.
Learn More. Are you having a hard time trying to decide between active and passive investing? Each approach has its merits, but neither is perfect. If you want to outpace the market without taking on the risks of stock picking, you may want to consider an alternative strategy that was developed by Nobel Prize-winning economists.
It's called factor investing, and it has outperformed the market for extended periods in the past. Stock picking is difficult and time-consuming, and it might put you in some risky positions when things don't go according to plan. On the other hand, buying index funds is a great way to mitigate those risks, but it's never going to provide the same upside potential that actively-managed portfolios can deliver.
Luckily, there's a hybrid strategy that can provide benefits from each style. You may see references to "rules-based passive investing" when reading about certain ETFs and mutual funds. These funds hold a large number of stocks from a given index, but they only hold stocks that meet specific predetermined criteria. These criteria can encompass all sorts of characteristics, including market capitalization , growth, momentum , valuation, quality, volatility, and liquidity.
Factor investing is a type of rules-based passive investing that only targets stocks displaying certain characteristics, or factors, that are shown to increase long-term performance. Theoretically, a portfolio composed entirely of stocks with these factors should outpace the market long term.
This can be done without incurring the time or expenses needed to pick individual stocks, which provides an opportunity to enhance returns without all the additional effort. Economists have spent the past 50 years trying to nail down which factors are the strongest determinants of stock performance. Famous work by Eugene Fama and Kenneth French in the s identified smaller market caps and lower price-to-book ratios as strong indicators that a stock would outpace its peers in the long term.
Thus, a small-cap company with low valuation multiples is likely to deliver better returns than a large-cap growth stock with a high valuation, according to their work. Subsequent studies have expanded upon these findings, and newer strategies commonly include momentum, low volatility , and quality e. Factor investing strategies don't completely abandon large-cap stocks or companies with high valuations. However, weighting in these portfolios is guided by factor scores, meaning stocks that grade the best tend to be the largest holdings.
This can be contrasted with market-weighted indexes, in which the largest companies are the biggest holdings. This means that factor-based allocations are more skewed toward smaller companies than you would expect in most passive strategies. If you're managing a large enough portfolio, you can probably just run a stock screen for a handful of factors, and then allocate based on the results of those screens.
However, that can get complicated, and it definitely requires a large sum of capital to make it work. Factor ETFs are a simpler solution for most investors, and there are numerous funds in this category. This fund holds large and mid-cap U.
It's sufficiently liquid and has a low expense ratio, both of which are great for investors. The Vanguard U. Unfortunately, there's no magic bullet for the stock market, and factor investing is no exception. This unique range of Factor ETFs aims to equip investors with tools to tilt their portfolio strategies towards factors within tactical or strategic asset allocation models.
The phenomenon of factor investing also known as 'smart beta' investing or 'alternative beta' investing has received a lot of attention amongst investors and the broad media. Factor investing has been researched continuously since the s, with academic researchers identifying that value, quality, low volatility and yield all tend to outperform the market portfolio in the long term. Different explanations can be found in literature, ranging from behavioural economics to corporate finance to statistical modelling.
Many studies document that indeed investment strategies based on these factors would all have beaten the World index. In essence, factors can be thought of as a consistent characteristic that is critical in explaining the risk and return profile with a group of related securities.
The four-decade run of outperformance by the MSCI factor indices1 proves that substantial and persistent factor premia have been present. But it also shows that the factor-based strategies have steadily been corrected over time i. The different behaviours of each of the following factors should lead investors to consider a wider range of factor investment opportunities in their portfolios. The successful implementation of factor investing requires detailed understanding of what it is about- the upside as well as downside risks.
Figure 1 shows the positioning of factor investing highlighting its presence between market beta and pure alpha. Factor investing is actually about getting exposure to rules-based, transparent and high-capacity strategies, where the selected stocks meet certain eligibility criteria, and are weighted proportionally to the factor exposure, e.
These strategies typically under-represent and tilt away from the market, so investors may benefit from diversification, but they also face other factor-related risks. For illustrative purpose only. A market capitalization weighted index market beta reflects the available opportunity set of equity investments.
If an investor wants to understand how equity markets perform, the best measurement is the market cap weighted benchmark. The market beta portfolio is also a natural benchmark for any other strategies, including factor investing or pure alpha investments.
The very DNA of factor investing is to provide tilts away from market capitalization weighted benchmarks, by following a standardized, disciplined, transparent and rules-based process of stock selection. Figure 2 shows the actual multi-step process required to construct a factor-exposed index. This process defines a rigorous portfolio construction, with stocks that best qualify for the factor exposure.
These strategies have very intuitive appeal on the one hand, and they are well researched and backed by empirical studies in the financial literature on the other hand. For example, the total shareholder yield strategy aims to select these companies that return capital - either through dividend payments or buyback programs - to their shareholder. To achieve this objective, this factor strategy will screen in the entire universe stocks that consistently deliver shareholder value.
It will then rank the companies in view of the shareholder yield, select top companies meeting certain threshold, and finally the strategy will overweight or tilt towards the most valuable stocks generating shareholder value. UBS Asset Management. Addition of alternative beta to the portfolio requires better understanding of the factor exposures and their properties. Each factor strategy has its own objective which determines its application in the portfolio. The value factor looks for relatively undervalued stocks as measured by fundamental company metrics e.
Numerous studies have demonstrated that value stocks tend to outperform their peers in the long-term. The outperformance can be rationalised by the fact that value investors take on additional risk by investing in cheap stocks, and expect higher return for risk-taking.
Value stocks are mostly looked for when financial markets experience off-equilibrium valuations. The low volatility factor selects companies whose stock market price variation is low and hence help to reduce portfolio risk. Low volatility stocks tend to outperform high volatility stocks; this is known as 'the low volatility anomaly', as it contradicts the conventional financial wisdom of risk-return trade-off.
However, low volatility stocks prove to be in high demand when uncertainty around financial markets increases, leading to their more robust market behaviour. The quality factor provides exposure to a portfolio of boring stocks. Quality companies are characterized by durable business models which should remain profitable, regardless of the business cycle.
In addition, quality stocks tend to have modest variability in earnings, e. High quality stocks, as selected by accounting criteria e. They are particularly in demand when financial markets are expected to experience turbulence.
The yield strategies are designed to capture the performance of companies that return above-average cash to shareholders either by paying dividends or through share buybacks. The excess cash can either be reinvested to finance further company growth, or it can be partially shared with the shareholders. Many yield-focused strategies select companies that have balanced pay-out ratios and have proven to generate persistent shareholder value in the long-term. Every factor strategy represents exposure to systematic sources of risk expressed through the factor load 2.
Figure 3 shows the historical factor loads of the four factor indices. This chart is a standard way to evaluate the factor load of specific strategies 3. In this framework, every investor must first assess the role of factor investing and what it aims to achieve through the investment.
For example, the quality companies have a relative negative tilt towards financial leverage defined as debt-to-equity ratio. This implies that quality companies use relatively low level of debt to finance increased operations, investments and business activities. While highly leveraged companies may have potential to generate higher earnings in expansive economy, then the cost of debt financing might turn excessively high with the economic downturn.
For many years, factor-based investment strategies have not been widely accessible and rather exclusive to a small group of investors.
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MSCI Factor Indexes are designed to help institutional investors seeking to capture the excess return of factors in a cost-effective and transparent manner. Equity factor investing was pioneered in the s based on the research, data and analytics created by Barra – today part of MSCI. Factor investing is the investment process that aims to harvest these risk premia through exposure to factors. We currently identify six equity risk premia.