PMC Market Commentary: August 29, 2014
As more sophisticated means of analyzing stock price performance have emerged over the years, factor investing increasingly has become a viable and important approach to portfolio management. A “factor” is generally considered to be a characteristic common to a group of stocks that helps to explain the risk and return of that group. There are certain factors that academic research has shown persistently generate a significant excess return, or a risk premium, over a market capitalization-weighted index. Factor investing is the systematic process by which these risk premia are captured.
There have been many factors identified by researchers over the past 40 years or so, with a handful generally recognized as being the most persistent: Value, Momentum, Size, Liquidity, Quality, and Profitability are among the most prominent. There is a large body of academic literature supporting the existence of, and intuition behind, these factors.
The capital asset pricing model (CAPM), introduced in the early 1960s by Sharpe (1964) and Lintner (1965) built upon the seminal Modern Portfolio Theory (MPT) work of Markowitz (1952) over a decade earlier. The CAPM is a so-called single-factor model in that it attempts to explain stock returns as being a function of one factor: the stock’s sensitivity to the overall market’s excess return (the return on the broad market less the risk-free rate), with the sensitivity represented by the stock’s beta.
While the CAPM provides a simple and intuitive framework for measuring the relationship between risk and expected return, its critics cite numerous shortcomings that have been manifested in poor empirical results. Fama and French (1993), among others, set forth a well-known three-factor model, which added size and value to the market factor. Fama’s and French’s research, which has been corroborated extensively in the academic literature, found that stocks with smaller market capitalizations and those exhibiting more pronounced value (such as a low P/E ratio or a high book-to-market ratio) characteristics performed better than stocks that were either larger or more growth-oriented.
In 1997, Carhart added momentum as an additional factor to the Fama-French three-factor model. The momentum factor is based on research that shows that stocks that have performed well over the past 12 months tend to continue that strong performance over the next month. Momentum has been demonstrated across many markets, asset classes and time periods, making it one of the most persistent and significant asset pricing anomalies. Several other factors have been put forth over the years, including liquidity (i.e., less liquid stocks outperform those with greater liquidity), quality (i.e., stocks whose companies have superior financial strength outperform stocks of less stable companies) and profitability.
Many investment managers use information about factor performance by “tilting” their portfolio to gain greater exposures to the factors, thereby attempting to capture the risk premium. Tilting a portfolio toward smaller cap and more value-oriented stocks, for example, is one way managers attempt to outperform the benchmarks.
While the performance if factors is cyclical – value does not always outperform growth, nor do small caps always outperform large caps – they seem to be persistent, even after a vast amount of research has been published about them. There are various explanations as to why these risk premia continue, with some asserting that there is some additional risk associated with the factors, and others promoting a behavioral finance rationale.
Whatever the reason behind the risk premia, it appears that factor-enhanced investing is here to stay.
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