Factor-Based Investing

The CFA Women’s Network hosted a lively and vibrant event featuring Patricia Halper, CFA, partner and co-chief investment officer at Chicago Equity Partners. Halper spoke to a room full of engaged members on the topic of factor-based investing which coincides with the popular topic “Smart Beta” investing. The subject is more relevant than ever as investors question the worth of fundamental active stock-pickers in search of both better performance and lower expenses. As a brief introduction, Halper has been working at Chicago Equity Partners for over twenty years as both a member of the quantitative research team and a portfolio manager.  Prior to CEP, she worked at Paine Webber on the institutional futures sales desk. Halper holds a bachelor’s degree in mathematics from Loyola University Chicago, a master’s degree in financial mathematics from the University of Chicago, and is also a CFA charterholder. Currently at Chicago Equity Partners, Halper utilizes factor-based investing strategies to support the firm’s equity decision making processes.

Simply stated, a “factor” is a characteristic of a security that explains its investment return. Factor investing in its most simplistic form can be described by the traditional CAPM equation: E(r) = rf * B(Rp-rf) where beta represents the single factor. In examining how a factor can be used towards making investment decisions, the question an investor must then ask is twofold: “Is this factor a good predictor of future price movements?” and then secondly “Which side of the factor (high beta or low beta in this case) will outperform the index?” Expanding upon a tradition single-factor model, Fama and French introduced the three-factor model in the 1990s which included beta, size and value.  In the late 1990s, quality factors came into light such as balance sheet quality, earnings quality, and quality of the management team. Today, there are hundreds of factors that investment professionals analyze to explain investment returns. Bottom line: factor investing is a known proven strategy that has been around for many years.  If you get the direction of correlated factors correct, you will likely outperform your benchmark.

Some of the most common factors used today include:

  • Value:  Low price/earnings, low price/sales, low price/book value
  • Quality: Strong management team, high earnings quality with lack of one-time items, low balance sheet leverage
  • Momentum: Both price momentum and earnings momentum generally provide outsized returns.
  • Size:  Smaller companies have outperformed larger companies over a long period of time
  • Volatility: Less volatile stocks provide higher expected return over the long term.

There is a key asterisks to the factors noted above. High value, high quality, positive momentum, small market cap, and low volatility have all shown to be positive factors of price performance…  over a 20 YEAR period. Often times, clients don’t have the investment horizon (or patience) to stick with a strategy that doesn’t work over several years, or even more commonly over several quarters.  In fact, the opposite of what is true in the long term (20 years) can be true in the short term (several quarters to even years). The key to understanding which factor is the most relevant to excess return is to understand what cycle of the market we are in. Halper described three market cycles:

  • Expansion: Most often markets are in expansion mode as markets generally trend higher. Momentum factor outperforms the most in expansionary periods (5%+ excess returns) and tends to work because investors tend to chase winners.
  • Downturn: At the end of the expansion period, you see a shift to Low Volatility and High Quality names with strong balance sheets that provide the best excess returns. This period can be considered recessionary with negative GDP growth.
  • Rebound: Finally, the rebound period doesn’t last long between when the downturn ends and when the expansion cycle begins—typically 2-3 quarters.  During this short time period, Value outperforms best.

Taking our single-factor observations above one step further, there is empirical evidence that If you know how to combine multiple factors into a model, a multi-factor portfolio will outperform a single-factor portfolio with less risk. There is a cyclicality in any one factor  and the cyclicality of factors increased during the global financial crisis.  It is best as an investment manager to pick at least two factors to structure your portfolio. That being said, you have to use two factors that are moderately correlated, otherwise one factor will tell you to buy and another to sell and you will naturally be holding the indexed market.. or cash!  How you combine factors, how you weight them, and how you allocate each factor is the name of the game for outsized returns. It is also critical to highlight that another key to successful factor based investing is having high quality data. High quality data has both a wide breadth and a long time horizon and without high quality data, your model will give false signals into which assets to buy and sell.

The analysis of factor based investing begs the question how is it related to the popular term in the industry right now “Smart Beta” investing.  Smart Beta strategies have shown tremendous AUM growth largely due to a general dissatisfaction with traditional equity asset managers. Asset allocators ask of Smart Beta products, “Can you perform better than a traditional passive index at a rate that is cheaper than active equity managers?” To put figures around the growth, in 2008, there was $100mm invested in Smart Beta strategies. Today, there is over $1 Trillion, a ten-fold increase in the last 10 years.  The largest smart beta funds, largely run by Vanguard and Blackrock, trade based on growth and/or value, what is otherwise a very traditional style-based factor investing that has been around for 20 years. When you take a closer look under the hood, even though these products are called “Smart Beta”, it is really the same principles just repackaged with a sexier word for the times. It’s not quant analysis, and if the product is only focused on a single factor, it’s not multi-factor investing either. If the Smart Beta product is only using a single-factor approach, it is simply “Quant 101” that has been around for over 20 years. Multi-factor Smart Beta products are a very small portion of the market which undoubtedly will grow over time. Investors should note that if they plan on buying a smart beta product, be aware of the sector exposures, as some have very high sector exposures which can overwhelm your factor exposure if you are overinvested in an industry that has sector specific issues.

What does the next 10 years look like? What factors will outperform in this current market environment? The Fed is now raising interest rates and ending its 10-year quantitative easing program.  How will turmoil in foreign markets and currencies impact our domestic equity and bond markets here at home? Only time will tell, but what is clear is that factor-based investing should be in every investment manager’s tool chest as they evaluate market trends and the price movements of its underlying securities.


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