The dictionary definition of a factor is "one that actively contributes to the production of a result." For example, the type of soil you choose will be a factor in how well your lawn grows. Similarly, there are certain characteristics of investments that will be a factor in how they perform. At Metric Financial, we focus on the factors of performance that have their roots in academics (not product marketing). By that we mean that a PhD evaluates decades of data on these factors and concludes that they are, in fact, contributors to excess investment returns beyond a simple market index. Further, we look for support from others in the academic community that the original work is accurate and sound. Finally, we look for proof that the factors are robust across geographies and asset classes (i.e. they work for stocks, bonds, etc.). So, what are the actual factors that have been identified and have broad academic support for excess returns? Read on...
Market – The "original factor" is the simplest; it states that stocks outperform bonds over time. In exchange for additional risk, of course.
Value – Among the more commonly supported factors, value demonstrates that less expensive investments outperform more expensive, growth-like ones over time.
Size – The size factor explains the phenomenon that smaller company investments outperform those of larger company ones over time.
Momentum – Have you ever waited for a stock to go up before buying it? Many investors wait for proof of an investment's worth before jumping in and that explains the momentum factor - investments with near-term outperformance continue to outperform in the near future.
Quality - As one might expect, the data shows that "quality beats junk". This simply means that companies that are profitable or healthy outperform their less healthy counterparts over time.
Volatility - Our sixth factor (notice how many circles there are in the Metric logo) demonstrates that lower volatility investments tend to outperform higher volatility ones over time.
It is important to understand how all of these factors work together. All of them tend to have very low correlations to one another, meaning their performance characteristics diversify one another. We use them together to access the potential for outperformance of all of them. We do not attempt to time them as we view the timing of any investment theme to be futile.
So why do we call this the Future of Active? For most of investing history, investors had to either pick their own investments or rely on active mutual fund managers to do so. The problem is that those mutual funds were (and are) expensive. The other problem, perhaps more importantly, is that the record shows that those expensive funds don't have a very good track record of outperforming a simple market index, which is what they are paid to do. Enter factors, which can strive for the same excess returns over a simple market at significantly reduced cost, greater tax efficiency and diversification, and potentially better returns. We discuss how to invest in them in greater detail here.