Choose Your Factor!

What is Factor Investing?

In the 1960s, William Sharpe and a team of economists developed the Capital Asset Pricing Model (CAPM). The model is an extension of Harry Markowitz’s work on Modern Portfolio Theory or mean-variance analysis. According to CAPM, a single factor drives stock market returns. That factor is beta, or the volatility of a security’s return relative to the market return.

e.g. the riskier the security, the greater the potential return.

The CAPM single factor model is considered the foundation of modern price theory for financial markets. In the decades following CAPM, research was published that identified additional drivers of stock market returns. Style factors such as Value and Size gained attention and led the way for the development of new multi-factor models.

The long and short of it (no pun intended) is that factor investing is an investment approach that constructs a portfolio based on characteristics that are ~proven~ to drive stock returns. Over the long-term, investing in equity style factors ~should~ generate above-market returns.

Let’s head to the charts and see how some equity factor indices are holding up.

Size Factor

The Size factor is outperforming the S&P 500 Index by 75bps year-to-date. This index is comprised of large and mid-cap stocks, with relatively smaller average market capitalization. It is not a pure small-cap stock index.

Value Factor

The Value factor is outperforming the S&P 500 Index by 130bps year-to-date. A much narrower spread than back in May when Value displayed a 7% YTD lead over the S&P 500 Index.

Quality Factor

Surprisingly, this index is having a very difficult time in 2022. The Quality factor is underperforming the S&P 500 index by -3.6% year-to-date. The ratio is trading below a significant support/resistance zone.

Momentum Factor

This momentum index cannot catch a break. Underperforming the S&P 500 Index by a whopping -8% year-to-date. The ratio is trading well below a significant support/resistance zone.

Volatility Factor

This Low Volatility index is performing quite well, outperforming the S&P 500 by nearly 5% year-to-date. The relative strength ratio is maintaining its uptrend line from the start of the year, and is trading above a well tested support/resistance zone.

Know Your Index!

There are many factor indices out there - both single and multi-factor. Several different sponsors have constructed their own indices, all with unique methodology and criteria. You may find a factor index that is limited to a certain universe of stocks e.g. large cap quality. Or you may find a momentum index with considerably different performance periods. At the end of the day, it’s important that we truly understand our exposure and the innerworkings of the index. e.g. criteria, backtests, rebalance schedule, natural sector tilts etc.

That’s enough out of me!

SM

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Sources worth checking out!

The arbitrage theory of capital asset pricing (Ross, 1976)

The relationship between return and market value of common stocks (1981, Banz)

Evidence of predictable behavior of security returns (Narasimhan, 1990)

Common risk factors in the returns on stocks and bonds (Fama & French, 1993)

The volatility effect: lower risk without lower return (Blitz & van Vliet, 2007)

This material is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. All indices are unmanaged and investors cannot actually invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses. Past performance does not guarantee future results. Please contact your financial professional for more information specific to your situation.