Rewarded risk factors are recognized as a fundamental component of equity returns. Envestnet | PMC believes that the most robust among the studied risk factors are value, momentum, quality, low volatility, and size. Like all return components, factors are cyclical in nature. Below, we take a look at the performance of these factors in the current market environment.
How factors have fared
- Factors posted mixed performance for the full year of 2021. Though it ended in the red for the last quarter, the value factor finally made up some ground for the full year. Messages are mixed and dependent on index when comparing growth and value in 2021. Value clearly bested growth in small caps. However, in large caps, the largest companies continue to overshadow all else, and the growth-leaning style of these tech-oriented firms meant large value stocks fell behind. As a result of these dynamics, indices that are large cap in nature like those based on the S&P 500 or Russell 1000 tend to show a growth advantage for the year, but broad market-based indices show performance that is similar between the two styles. In any case, value has much ground to make up over the long term across the market capitalization spectrum. Tightening monetary policy and expected higher rates may bode well for another rally in domestic value stocks in 2022, particularly relative to their growth counterparts.
- It was a year of reversals for the momentum factor. Early in the year, market leadership shifted dramatically from high growth, large caps to value-oriented and smaller cap names, only for that leadership to shift back again as the year wound down. The momentum factor falters in markets such as this, where leadership whipsaws among sectors, and it is no surprise this was the worst performing factor for the full year of 2021 here and abroad.
- Minimum volatility’s underperformance was also on brand given the upward trending, risk-on market environment of the last year. Concerns over COVID variants and their impact on economic recovery were particularly damaging for small cap stocks in the last half of the year, and the small cap factor lagged the broad market as a result.
- No factor will consistently win over short-term periods because of the vagaries of the market cycle. However, as seen above, over the long-term they tend to show a positive return relative to the broad market. Factor-based investing is a marathon, not a sprint, and patient investors can capture the premia offered by these risk factors by riding out market environment waves and staying the course.
Back to basics
With roots in decades of complex academic research and papers published in prestigious journals, factor-based investing could understandably be written off as too intimidating for retail investors. The asset management industry as a whole has likely contributed to this image, as we are as guilty as anyone of overcomplicating the message of factor-based investing in our zeal to tie it back to the solid academic foundations on which it stands.
The way to make the factor-based message resonate is to go back to basics and keep it simple. At a high level, factor-based investing offers the potential to outperform the market at a lower cost with higher capacity than traditional active strategies. Point-by-point support for this statement solidifies the message:
Factor-based investing offers the potential to outperform the market…
Factor-based investing is active management. Just as traditional active managers attempt to pick individual stocks that they believe will outperform the broad market, factor-based strategies seek market outperformance through stocks with the characteristics that academic studies have shown tend to earn a higher risk-adjusted return than the market over the long-term. The difference between factor-based strategies and traditional active managers is not their objectives, but their implementation.
at a lower cost…
Where traditional active strategies rely on portfolio manager(s) to pour over stock universes and use their unique abilities to pick winners, factor-based strategies are entirely quantitative in nature. They rely on mathematical models to screen the universe and identify securities with the characteristics that are expected to deliver a long-term higher risk-adjusted return, such as value, momentum, and quality. Traditional active managers look for these characteristics too, but because factor-based strategies rely on repeatable mathematical models and not unique skill, they can be offered at a much lower fee.
Based on Morningstar’s most recent survey of the universe, which includes factor-based products in the broader universe of quantitatively managed strategic beta strategies, the asset-weighted average cost of this type of strategy is more than two-thirds less than the cost of traditional active strategies and only slightly more than the average cost of traditional passive strategies. And importantly, additional research has shown that most traditional active managers don’t add value over and above the return earned by less expensive factor-based products, and even fewer do so after fees. Why pay the higher fee for a return you can get at a fraction of the cost?
Not only is the explicit fee of factor-based strategies lower than that of traditional active managers, the time required to pick and monitor these strategies for advisors and home offices is arguably lower. The quantitative, repeatable nature of the investment process coupled with a widely vetted investment philosophy may be the easier path to market outperformance than relying on a star manager to pick individual securities using proprietary processes.
with higher capacity than traditional active strategies.
Traditional active equity strategies tend to be concentrated in less than 100 securities, and most hold less than 50 positions. Conversely, factor-based strategies are generally broadly diversified across hundreds of positions in order to reduce stock-specific risk with the intent to garner their return from targeted factors. The more concentrated traditional strategies eventually close to new inflows as their asset base becomes too large to allow them to nimbly deploy their process, leaving advisors and investors searching for other options. Factor-based strategies spread assets among numerous holdings, giving them a much longer runway before closure.
Strung together, the message stands: Factor-based investing offers the potential to outperform the market at a lower cost with higher capacity than traditional active strategies. It can be a foundational part of the portfolio construction toolkit for the long-term investor, and its simplistic appeal is supported by the complexity of its academic roots.
- Value: The tendency for cheap assets to outperform expensive assets. (See Basu, S. “Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios: A Test of the Efficient Market Hypothesis.” Journal of Finance, 1977.)
- Momentum: The tendency for assets that have performed well over the past year to continue to perform well over the near-term. (See Jegadeesh, N and S. Titman. “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.” The Journal of Finance, 1993.)
- Quality: The tendency for higher quality companies – those that are more profitable and safer – to outperform lower quality companies. (See Novy-Marx, R. “The Other Side of Value: The Gross Profitability Premium.” Journal of Financial Economics, 2013.)
- Minimum Volatility: The tendency for lower beta, less volatile stocks to outperform higher beta, more volatile stocks. (See Ang, A., Hodrick, R. Xing, Y. and X. Zhang. “The Cross-Section of Volatility and Expected Returns.” The Journal of Finance, 2006.)
- Size: The tendency for small capitalization stocks to outperform large capitalization stocks. (See Banz, R. “The Relationship Between Return and Market Value of Common Stocks.” Journal of Financial Economics, 1981.)
- The MSCI USA Momentum Index is designed to reflect the performance of an equity momentum strategy by emphasizing large and mid cap US stocks with high price momentum.
- The MSCI USA Quality Index is designed to capture the performance of large and mid cap US quality growth stocks by identifying stocks with high quality scores based on three main fundamental variables: high return on equity (ROE), stable year-over-year earnings growth and low financial leverage.
- The MSCI USA Minimum Volatility is designed to reflect the performance characteristics of a minimum variance strategy applied to the large and mid cap US equity universe by optimizing the MSCI USA Index for the lowest absolute risk (within a given set of constraints).
- The MSCI USA Enhanced Value Index is designed to represent the performance of large- and mid-cap US equity securities that exhibit higher value characteristics relative to their peers within the corresponding GICS® sector. The value investment style characteristics are defined using price-to-book, price-to-forward earnings, and enterprise value-to-cash flow from operations.
- The MSCI USA Small Cap Index is designed to measure the performance of the small cap segment of the US equity market.
- The MSCI World ex USA Momentum Index is designed to reflect the performance of an equity momentum strategy by emphasizing large and mid cap stocks across developed market countries excluding the US with high price momentum.
- The MSCI World ex USA Quality Index is designed to capture the performance of quality growth stocks by identifying stocks of large and mid cap stocks across developed market countries excluding the US with high quality scores based on three main fundamental variables: high return on equity (ROE), stable year-over-year earnings growth and low financial leverage.
- The MSCI World ex USA Minimum Volatility Index is designed to reflect the performance characteristics of a minimum variance strategy applied to the MSCI large and mid cap equity universe across developed market countries excluding the US by optimizing the MSCI World ex USA Index for the lowest absolute risk (within a given set of constraints).
- The MSCI World ex USA Enhanced Value Index is designed to represent the performance of large- and mid-cap universe across developed market countries excluding the US that exhibit higher value characteristics relative to their peers within the corresponding GICS® sector. The value investment style characteristics are defined using price-to-book, price-to-forward earnings, and enterprise value-to-cash flow from operations.
- The MSCI World ex USA Small Cap Index is designed to measure the performance of the small cap equity universe across developed market countries excluding the US.
- The MSCI USA Growth Index is designed to represent US large and mid cap securities exhibiting overall growth style characteristics as measured by five growth variables.
Past performance is not indicative of future results. The information, analysis and opinions expressed herein are for informational purposes only and do not necessarily reflect the views of Envestnet. These views reflect the judgment of the author as of the date of writing and are subject to change at any time without notice. Nothing contained in this piece is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type.
Sarah Abernathy, VP, Senior Investment Analyst, Envestnet
Sarah Abernathy, CFA, CAIA, has spent her career assisting RIA, bank, and broker dealer home office clients and their advisors with money manager research, due diligence, and selection, as well as advising on asset allocation, capital market assumptions, and tax optimization. Ms. Abernathy holds a bachelor’s degree with dual majors in Finance and Economics, and a minor in Spanish, from the University of Northern Iowa. She has earned the CFA and CAIA charters, and is a member of the CFA Institute, the CFA Society of Iowa and the CAIA Association.