Equity Factor Investing

Institutional investors are always looking for an edge to improve their portfolio performance. A current candidate for that edge in equity investing is the use of factors. Factor investing brings quantitative rigor to sizing up the returns of stock markets, to gauging the success of active managers and to building distinct portfolios.

There is no consensus as to how many factors drive stocks, or how exactly to define some of the factors, but their application to equities adds a new analytical dimension to traditional equity styles and gives sponsors greater precision and transparency in understanding what moves their portfolios.

Over time, financial economists have identified hundreds of individual quantitative signals, most of which are fleeting, but the science has bundled up the ones that have endured and grouped them into factors: value, momentum, quality, company size, and volatility. Some practitioners also track factors for dividend yield and stock liquidity.

As Mark Stahl, senior vice president at consulting firm Callan, says, “Conventional capitalization- weighted indexes certainly have exposures to factors, but, for investors who believe in a factor approach, there are better ways to home in on them.”

Indexes and portfolios based on single factors contain hundreds of stocks but represent only a small fraction of broad market indexes.

“Over short periods, factors can show high correlation to one another,” notes Feifei Li, head of investment strategy at Research Affiliates, a publisher of factor indexes. “When companies that have a strong quality factor are doing well and attracting inflows, they are probably doing well in momentum at the same time, as we saw in 2018.”

Individual factors can be fairly potent and require handling with care. Momentum strategies call for frequent trading and thus incur high transaction costs. Jay Love, a partner in consulting firm Mercer, points out that value has been one of the most effective factors over the long term but has slipped out of favor in the last eight years.

“Moreover,” says Stahl, “the quality factor is hard to define, and it might correlate highly to other factors, such as value in 2018.”

“There’s also the possibility that, through crowding and more money flowing into a given factor, its premium could erode,” observes Jon Pliner, head of delegated portfolio management at consultant Willis Towers Watson.

Dimensional Fund Advisors has been at factor investing for almost 40 years. “Through our valuation framework, we find factor premiums for value, company size and profitability,” says Marlena Lee, co-head of research. “Realized returns are ‘noisy,’ and sometimes they are negative, but our framework says investors should expect those premiums every day, and in every market and sector.” —John Keefe

Art by Andrea D’Aquino