Factors: The Future of Active

What Are Factors?

A factor is a quantifiable characteristic that can help explain why some stocks have returns higher than those of a simple market index like the S&P 500 over time.

The five factors that Metric Financial uses in stock portfolios are:

1. Momentum (recent outperformance relative to the market may continue)
2. Value (less expensive stocks may outperform more expensive ones)
3. Size (smaller company stocks may outperform those of larger companies)
4. Quality (profitable companies may outperform unprofitable companies)
5. Low Volatility (lower volatility stocks may offer better risk-adjust returns than volatile ones)

Overview On The Future Of Active:

The investment industry has changed dramatically over the last few decades. Technology and data allow information to be accessed faster than ever before. In the past, we needed humans to identify companies with low P/E ratios (value companies) or high return-on-equity (quality companies). Now, technology allows us to screen for that information, and this means two things: (1) finding information becomes significantly cheaper, and (2) the companies we find are based on fact, not emotion or judgment. All of this evolution in data availability and technology leads to a couple of important innovations.

Why Invest In Factors?

Investing in factors has several benefits for investors. First, their primary purpose is to deliver a return above that of “the market” (i.e., the S&P 500, etc.). Compared with active mutual fund portfolio managers, they are demonstrated to be more effective in the long run*. Second, compared to actively managed mutual funds, these portfolios are also lower-cost, and more tax-efficient for investors because they use exchange-traded funds (ETF) instead. Finally, when combining factors, investors may get improved diversification to different market environments without trying to time the market or make tactical trades.

Why Invest Using ETFs?

Exchange-Traded Funds (or ETFs), in our opinion, are better for investors than traditional mutual funds for a variety of reasons. ETFs are cheaper to own because they are typically passively tracking an index, whereas most mutual funds have active managers trying to handpick stocks to beat the market. ETFs are also more tax-efficient for investors and can be liquidated easier than mutual funds. 

How Does This Work?

The nuts and bolts behind putting factors to work is actually much simpler than one might think. Most people are familiar with the S&P 500 stock market index. That index is created by screening for the 500 largest US companies by market capitalization. That means they are all ranked by the number of shares of stock they have sold to investors multiplied by the current stock price. For example, on August 17, 2021, Facebook had a market capitalization of just over $1 trillion. This gave Facebook a much smaller representation in the S&P 500 than Google, which had a market capitalization of $1.83 trillion.

If that sounds like an arbitrary way to invest in a stock, we agree. Enter an index based on factor criteria. For this instance, we will focus on the Value factor, described above. Let’s stick with the same two stocks. On August 17, 2021, Google had a price/earnings ratio (a measure of how expensive a stock is) of 29.67. That means the company’s stock price is 29.67 times higher than their earnings per share. In contrast, Facebook’s price/earnings ratio was 26.51. Therefore, Facebook is the cheaper stock. So in the S&P 500 index, Google has a greater representation, but in a “Value” index, Facebook gets the bigger share.

So how do we get it to work? That’s even simpler. Now that we have created a new index with the less expensive stocks getting a higher weighting, we just need an investment that can buy all the stocks in it. This is most often done with an Exchange Traded Fund (ETF) instead of a mutual fund because, as noted earlier, ETFs tend to be cheaper to operate, more tax-efficient, and have greater liquidity. For example, the Invesco S&P 500 Enhanced Value ETF (ticker symbol SPVU) does exactly what we just described – it starts with the S&P 500 and invests only in those stocks with the highest “value score”.

How Do Factors Diversify A Portfolio?

At Metric, we don’t just pick factors that are meant to beat the market in the long run. We also want factors that diversify one another. What good are they if they are all doing the same thing at the same time or the exact opposite at the same time? Therefore, we select factors that have favorable correlations. A correlation of 1 would mean they were all doing the same thing at the same time, while a correlation of -1 would mean they were simply canceling each other out. A zero would mean they were truly unrelated to one another and gave diversification. That is rare, so we simply look for factors with correlations sufficiently different from -1 or +1. A low correlation is good because it demonstrates the diversification of a portfolio using factor investing. While they will vary over time, the five factors we use had no correlations higher than +0.76 and none lower than -0.69, and most were well within the -0.5 to +0.5 range**, meaning that our portfolios should provide valuable diversification. 

*Source: Standard & Poor's Index Versus Active study.

**Source: Morningstar; For the period 2004-2020.

All market capitalization and price/earnings data is sourced from MarketWatch.