One of the most important discoveries in finance over the past few decades is that stocks of firms that share certain fundamental characteristics called “factors” exhibit different return and risk characteristics than the overall market. Critical to investors is the fact that, over long periods of time, certain of these factors have earned excess returns compared to the overall market.
Broadly speaking, these factors can be distilled into the following categories:
- Value: Stocks that are low-priced in relation to earnings, dividends, cash flow or book value, on average, have outperformed growth stocks over long time horizons.
- Size: Stocks of small and mid-size companies have earned, on average, higher returns than stocks of large companies over long time periods.
- Momentum: Stocks that have exhibited positive momentum – i.e., have performed relatively well over the past 3 to 12 months – have outperformed, on average, over long time horizons stocks that display negative momentum.
- High Yield: Stocks of companies that pay higher dividends, on average, have earned superior returns to lower and non-dividend paying stocks over the long run.
- Quality: Stocks that have evidenced superior profitability in relation to capital have, on average, outperformed firms with poorer profitability in relation to capital over long time horizons.
- Low Volatility: Stocks that have exhibited low volatility have, on average, outperformed stocks that display high volatility over the long run.
There are two primary explanations for the higher returns associated with these factors. One is that the higher returns represent risk premiums – i.e. compensation to investors for incremental risks beyond that of the total stock market. For example, small company stocks are not only more volatile than stocks of large companies but are also much less liquid. Value stocks tend to include a higher proportion of heavily indebted companies which dramatically underperform the overall market during periods of extreme market stress.
The second explanation is offered by behavioural finance. Investors’ cognitive biases such as “myopia” and “overconfidence” can lead to the persistent mispricing of certain securities. For example, many investors are attracted to the episodic outsized returns of high volatility, low quality stocks and chase these types of stocks despite a pattern of longer-term underperformance. Overly optimistic investors overestimate the earnings prospects of growth stocks while underestimating those of value stocks; value stocks then generate superior returns as investors eventually realize that earnings in the value universe are better than initially expected. The “herding” behaviour of investors has been advanced as an explanation for the returns associated with the momentum factor.
Social phenomena such as the “bandwagon effect” can also distort prices. The “madness of crowds” – as evidenced by the railway mania of the 1840’s, the Florida real estate boom of the 1920’s, the Japanese bubble of the 1980’s and the internet mania of the 1990’s – is a well-documented recurring market spectacle. Investors’ infatuation with extremely expensive US growth names these last several years will likely be added to the textbooks as the most recent example.
Factor performance can vary because of business cycle influences, market sentiment, interest rate changes, sector composition and other variables. The following chart sets out the return earned by each factor globally in 2022 compared to the overall broad market. (See Appendix I for Sources).
High dividend stocks came in first on relative factor performance with (only) a -6.7% loss in 2022. Value stocks were not far behind, delivering -8.8% for the year. Low volatility stocks were also a better place to be than the broad market in 2022, losing -9.8%. Only in a global bear market year would the prior figures be welcome ones and indeed the global broad market lost investors a full -18.0% for the year. Small-mid size stocks and momentum stocks performed only slightly worse than the broad market. However, quality stocks – which were the #1 performer in 2021 up 22.5% – suffered a reversal in 2022 as hefty interest rate increases prompted investors to shift favor to “low duration” value stocks and it lost -23.4%.
While the outperformance of any one factor in any given year is unpredictable (making “factor timing” a mug’s game) diversifying across factors and systematically rebalancing allocations can augment portfolio returns over time. As illustrated by the following graph depicting the cumulative growth of $100 USD invested since 2000, the global multi-factor portfolio has created a whopping 59% more wealth than the global broad market index (see Appendix I for the indexes used and disclaimer).
Fifteen years ago, “factors” were a fascinating corner of the capital markets but of little practical use to individual investors. Since then, with the advent of low-cost exchange traded funds and the creation of transparent, rules-based factor indices by a range of index providers, a multi-factor portfolio has moved from academic theory to concrete application. Patient investors finally have an empirically sound approach to pursuing market-beating returns.
|Global Factor/Portfolio/Market||Index (USD)|
|High Dividend Yield||MSCI ACWI High Dividend Yield|
|Low Volatility||MSCI ACWI Global Minimum Volatility|
|Momentum||MSCI ACWI Momentum|
|Quality||MSCI ACWI Quality|
|Size||MSCI ACWI SMID Cap Index|
|Value||50% MSCI ACWI Large Cap Value
50% MSCI ACWI SMID Value
|Global Multi-Factor||Equal Weight of the Above 6 Factors;
|Broad Market||MSCI ACWI Investable Market Index|
Tacita Capital Inc. (“Tacita”) is a private, independent family office and investment counselling firm that specializes in providing integrated wealth advisory and portfolio management services.
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