• The guide digs into the growing factor zoo to find the factor premia worth considering in a portfolio. The authors introduce five criteria any factor should meet, discuss the seven factors that qualify, and why other factors fall short of consideration

• Data mining often finds false factors that result from randomness. Data mining has created a growing “factor zoo.”

• There is always a risk that a factor has been arbitraged out of existence.

• Commodities and timberland are the only two alternative investments with no correlation to stocks.

• Factor diversification is a more effective diversifier than asset class diversification.

• Factor Investability Test:

  • Persistent – factor delivers historically reliable returns across time and economic regimes.
  • Pervasive – factor delivers returns across different asset classes, sectors, and countries.
  • Robust – factor delivers returns across various metrics versus only one metric.
  • Intuitive – factor makes sense.
  • Investable – factor delivers returns not only on paper but in reality, after fees.

• To earn the premium of any factor investors must accept the risk of long periods where the premium is negative.

• Market Beta Premium

  • Beta is the amount an asset moves relative to the market or the correlation between the asset’s returns and the market’s returns.
  • The market beta premium in the U.S. is 8.3% (1927 to 2015). It’s the excess returns stocks earn over T-bills.

• It’s been positive in almost every country since 1900, ranging from 3.1% to 6.3%.

• Size Factor

  • Size Premium – small-cap returns minus large cap returns or small minus big (SMB). Small and large caps are divided by deciles. Small is deciles 6 to 10. Large is deciles 1 to 5.
  • Size Premium in the U.S. is 3.3% (1927 to 2015).
  • Also persists in developed (ex-US) and emerging markets.
  • If the size premium is constructed using the smallest 30% versus the largest 30%, the premium increases. As the definition of small vs. large is narrowed (i.e. smallest 20%, 10%, etc.), the premium increases further.
  • Small Companies typically carry: more leverage, smaller capital base, more volatile earnings, lower profitability, uncertain cash flows, less liquidity, unproven track record, unproven management, more volatile stock prices, and investors favor stocks with potential lottery-like returns. All are possible risks that explain the premium.
  • Monetary policy affects the size premium. The premium shows up during periods of expansionary policy.
  • Size premium varies across the economic cycle. Small companies grow faster than large companies during economic upturns but do worse during downturns. Small caps produce low returns during recessions.
  • Small Cap Growth is the exception, underperforming the market.
  • Size works better with other factors: value, momentum, quality, and low-beta all showed improvement.

• Value Factor

  • Value Premium – value stock returns minus growth stock returns or high minus low (HML). Growth is defined as the 30% of stocks with the highest book-to-market ratio. Value is the 30% of stocks with the lowest book-to-market ratio. Book-to-market is the common metric used by academics.
  • Persists across developed and emerging countries.
  • Returns were higher in value stocks that had cut dividends by 25% or more, high debt-to-equity ratio, and high earnings volatility.
  • Risk-based explanations: value stocks tend to outperform growth stocks during falling interest rates, increases in money supply, and economic expansion.
  • Behavioral-based explanations: investors are too optimistic of growth stock performance and too pessimistic toward value stocks or investors confuse popularity with safety, leading to growth stock becoming overvalued and value stocks being undervalued.
  • The value premium may persist beyond one year — up to three years.

• Momentum Factor

  • Momentum Premium: assets that have performed well in the recent past will continue to perform well in the future. Defined as returns over the last 12 months (excluding the most recent month) or up minus down (UMD) The most recent month is usually excluded because it tends to show a reversal.
  • Momentum Premium in the U.S. is 9.6% (1927 to 2015).
  • Two Types:
    • Cross-Sectional Momentum: measures the relative performance of an asset versus other assets in the same asset class.
    • Time-Series Momentum: aka trend-following measures the absolute performance of an asset versus its own performance (covered below).
  • Persists across asset stocks, bonds, currencies, commodities, and county.
  • It’s strongest in small caps, especially microcaps.
  • Momentum tends to be a high turnover strategy, which can increase trading costs. To avoid high turnover, momentum can be used to filter out assets to avoid, lowering turnover. Works well in combination with a value factor.
  • About 52% of the premium comes from the long side.
  • Behavioral Explanation: Investors are slow to react to new information (underreaction) and then chase returns (overreaction).
  • Momentum returns fall from 8.9% to 2.9% over a six-month period, for stocks with continuous information.
  • The premium exists in other periods – 6 and 9 months, for example.
  • Long/Short momentum strategies experience crashes on the short side (due to quick market reversals) during periods of higher volatility.
  • “The way to mitigate the risk of crashes is to vary exposure to momentum over time. The authors found that if they scaled exposure to momentum (using the realized variance of the daily returns in the previous six months), the risk-managed momentum strategy achieves a higher cumulative return with less risk.” It adjusts the amount of money invested based on volatility because volatility typically rises prior to drawdowns. Less (more) money when volatility is high (low).
  • Alternatively, diversifying across factors can lower the risk of momentum crashes.

• Profitability & Quality Factor

  • The Quality and Profitability factors are broad with a lot of metrics lumped into each that meet the investability test.
  • Profitability Factor

    • Gross Profitability:

      • Profitable companies generate higher returns than unprofitable companies, with the most profitable outperforming the least profitable.
      • shows a similar predictive power as book-to-market.
      • Predictor of future growth, earnings, free cash flow, and payouts.
      • High asset turnover drives returns of profitable companies.
      • High gross margins drives returns of “good” growth stocks.

    • Cash-based Operating Profitability (excluding accruals): Tends to outperform other profitability metrics: operating profitability, gross profitability, and net income-based profitability.

    • Return on Equity: high ROE companies outperform low ROE companies.

    • Return on Invested Capital: high ROIC companies outperform low ROIC companies.

    • The Profitable Premium increases during economic drawdowns because profitable companies perform better than unprofitable companies during recessions.

    • Behavioral Explanation: investors underreact to profitability news, leaving those companies undervalued.

    • Combines well with value strategies, tends to be low turnover, and reduces volatility. Tends to perform better when value performs poorly. A value/profitability combo never experienced a losing five-year period.

    • Total Profits/Assets, Total Profits/Sales, and FCF/Assets also show a premium.

  • Quality Factor
    • Defined as quality minus junk (QMJ).
    • Combines well with value.
    • Net Shares Issued: Companies that decrease net shares outperform companies that increase net shares.
    • Accruals: Companies with low accruals outperform companies with high accruals.
    • Net Operating Assets: “The difference on a firm’s balance sheet between all operating assets and all operating liabilities, scaled by total assets, is a strong negative predictor of long-run stock returns.”
    • Asset Growth: Companies with high asset growth underperform companies with low asset growth.
    • Investment/Assets: Companies with high capital investment-to-assets underperform companies with low capital investment-to-assets.
    • Distress: Companies with a high chance of failure underperform.
    • Return on Assets: More profitable firms outperform less profitable firms.
    • Ohlson O-Score: Measures risk of bankruptcy. High bankruptcy risk leads to underperformance.
    • Capital Investment: Companies that increase capital investment underperform those that don’t.

• Term Factor

  • Term Premium is the long government bonds minus 1-month T-bills.
  • The premium is 2.5%.
  • Persistent globally.
  • Longer maturity = higher premium.

• Carry Factor

  • Carry Premium is defined as higher-yielding assets outperform lower-yielding assets assuming prices do not change.
  • Ex: currencies of the highest interest rate countries outperform currencies of the lowest interest rate countries.
  • Persists across asset classes.
  • Carry trade strategies have a risk of crashes when stock markets crash. Lower interest rate currencies act as “safe havens” during global shocks.
  • Combining carry and trend following produces a better return.

• Research shows factor premia declined less, after publication, in stocks that are more costly to arbitrage.

• There is less evidence of factor premia decline, after publication, internationally due to arbitrage.

• Limits to Arbitrage: Why Anomalies Might Persist:

  • Institutions are prohibited by their charters from shorting.
  • Cost of shorting is too expensive and/or limited supply.
  • Risk of shorting (unlimited loss) is too high, forced liquidation, or recalled stocks.
  • Trading costs and taxes can also limit arbitrage.
  • Career Risk: Fund managers are unwilling to stray too far from their benchmark for fear of losing their job.

• Tracking Error: the risk of underperforming a benchmark. It can lead to investors confusing strategy and outcome and abandoning a solid strategy at inopportune times. A strategy should be judged on its face before the results because outcomes are not guaranteed in investing.

• Relativism: the tendency for investors to compare their performance against a benchmark (or others), which affects their satisfaction with the strategy and their willingness to stick with it.

• Recency Bias: recent events have a larger impact on a person’s thoughts and decisions. It lead investors to put too much weight on recent events like performance and buy what has recently performed well while selling what has recently performed poorly — when they should be doing the opposite.

• Dividends

  • Research shows that dividend yield alone does not predict future returns.
  • Returns of dividend strategies are better explained by exposure to other factors. For example, strategies based on companies with rising dividends are better explained by quality and profitability factors.
  • However, dividends do provide psychological benefits — receiving dividends avoids regret from selling stock and the effect of loss aversion. “People suffer more regret when actions are taken than when actions are avoided. In selling stock to create the homemade dividend, a decision must be made to raise the cash. When spending comes from the dividend, no action is taken, thus less regret is felt. Again, this helps explain the preference for cash dividends.”
  • Dividend yield combined with net share buybacks and debt reduction does improve returns.
  • Companies with a lower payout ratio outperform those with a higher payout ratio.

• Low Volatility Factor

  • Low Volatility Factor is that defensive less volatile stocks outperform aggressive, high volatile stocks.
  • Persists in developed and emerging markets.
  • Low Vol factor may be better explained by profitability and size (large caps).
  • A combination of a highly volatile stocks and low short interest outperformed a market index by 7%. A combo of highly volatile stocks and high short interest underperformed. In fact, high volatility/low short interest outperformed during prior crashes in 2000 and 2008.
  • Short Interest — stocks with high short interest perform poorly on average. Stocks with high borrowing costs also predict poor returns.
  • Low-vol strategies are exposed to term risk — more correlated with long-term bond returns.
  • Low-vol strategies tend to shift exposure between growth and value regime — spending about 62% of the time in value regimes, 38% in growth regimes. Most of the outperformance can be explained by its time in the value regime as it underperforms in the growth regime.
  • Low-vol factor is predictive of future low volatility.
  • One way to take advantage of the low-vol factor is to screen out high volatile or high beta stocks.

• Default Factor

  • Default Premium is long-term investment grade bonds minus long-term government bonds.
  • The source of the premium is explained by default/credit risk. However, taking additional credit risk offers an almost insignificant additional return over government bonds, historically.
  • Most of the return of high-yield bonds is explained by equity risk. High-yield bonds are also highly correlated with stocks, especially when stocks perform poorly.
  • Long term, the correlation between Treasuries and stocks is nearly 0 (uncorrelated), but that correlation varies over time. Bonds are negatively correlated when stock volatility rises. During stock market drawdowns investors flee to safe government bonds. So Treasury bonds are a strong diversifier for stocks during drawdowns. Other bonds do not carry the same diversification benefits.

• Time-Series Momentum

  • Time-Series Momentum is the trend of an asset compared to its own past performance.
  • Persists internationally and across other asset classes.
  • Does not experience crashes like cross-sectional momentum.
  • Dual Momentum — combines time-series and cross-sectional momentum. It buys the strongest winning portfolio and shorts the weakest losing portfolio.
  • Trend following performs well during extreme outlier years for the stock market. “During the 10 largest drawdowns experienced by the traditional 60/40 portfolio over the past 135 years, the time-series momentum strategy experienced positive returns in eight of these stress periods and delivered significant positive returns during a number of these events.”
  • Tends to be a high turnover strategy.

• Combining Multiple Factors

  • Using multiple factors is the optimal approach.
  • Adding an additional factor only exposes a portfolio to a small portion of the factor’s premium. The overall return will only see incremental improvement, if at all.
  • Investors need to weigh the trade-offs of negatively correlated factors like value and momentum.
  • Portfolios get a diversification benefit from factors that not perfectly correlated.

• Sports Betting

  • Moskowitz tested the behavioral models on sports betting — baseball, football, basketball, hockey — to see if behavior drove outcomes or if markets were efficient.
  • Sports betting is not profitable. Returns are flat before fees and negative after fees. The only way to get a positive return is by eliminating the fees.
  • Momentum exists and predicts returns. Betters pushed up prices. The opening prices set by bookies were more correct than the prices when betting was closed.
  • Value exists and predicts returns. Cheap bets got cheaper before reversing.

Quotes

“First, the momentum and value effects move betting prices from the open to the close of betting. These patterns are completely reversed by the game’s outcome, and in a manner that is consistent with how these premiums work in financial markets. Second, the fact that both momentum and value have predictive value in sports betting markets, and that these factors have the same negative relationship (momentum pushes prices up and value pushes prices down) that they demonstrate in the financial markets, provides support for the idea that these factors do incorporate at least some behavioral components in financial markets.”

“All but short-maturity corporate bonds contain equity-like risks. And the lower the credit rating, the greater the contagion risk. Thus, investors who choose to include an allocation to either high-yield bonds or longer-term investment-grade bonds should consider them as hybrid instruments, combining the characteristics of both U.S. Treasuries and equities.”

“The duration — in terms of sensitivity to interest rates — of the portfolios increases monotonically with the dividend yields. Stocks with high dividends tend to experience decreases in returns when long-term bond yields increase, while those with low dividends tend to earn higher returns when interest rates hike up.” — “Equity Duration: A Puzzle on High Dividend Stocks”

“Diversification means accepting the fact that parts of your portfolio may behave entirely differently than the portfolio itself.”

“Relativity worked well for Einstein, but it has no place in investing.” – John Bogle (quoting an anonymous fund manager)

“One cannot judge a performance in any given field (war, politics, medicine, investments) by the results, but by the costs of the alternative (i.e., if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly, the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).” — Nassim Taleb, Fooled by Randomness

“First, anomalies can persist even when they become well known… Second, research does appear to lead to increased cash flows from investors seeking to gain exposure to the premiums, which in turn leads to lower future realized returns. However, we note that where logical, risk-based explanations exist, premiums should never disappear… However, we do caution investors not to automatically assume that future premiums will be as large as the historical record.”

“High-quality companies have the following traits: low earnings volatility, high margins, high asset turnover (indicating efficient use of assets), low financial leverage, low operating leverage (indicating a strong balance sheet and low macroeconomic risk), and low stock-specific risk (volatility that is unexplained by macroeconomic activity). Companies with these attributes historically have provided higher returns, especially in down markets. In particular, high-quality stocks that are profitable, stable, growing, and have a high payout ratio outperform low-quality stocks with the opposite characteristics.”

“It has been shown that other measures of what is referred to as fundamental momentum, such as earnings momentum, changes in profit margins, and changes in analysts’ forecasts, produce premiums.”

“At its most basic level, factor-based investing is simply about defining and then systematically following a set of rules that produce diversified portfolios.” – Cliff Asness

“Belief in the factors you choose is vital not just to make sure they are real, and not just data mining, but because without well-formed, strongly held beliefs (perhaps stemming from persistence, pervasiveness, robustness, intuition, and investability!), nobody will stick with their investing process through the inevitable tough times.” — Cliff Asness

“Growth stocks are high-duration assets (much of their value comes from expected future growth), making them similar to long-term bonds. Value stocks, on the other hand, are low-duration assets, making them more similar to short-term bonds.”

“Investors in glamour stocks are likely to under-react to information that contradict their beliefs about firms’ growth prospects or reflect the effects of mean reversion in performance. Similarly, value stocks, being inherently more distressed than glamour stocks, tend to be neglected by investors; as a result, performance expectations for value firms may be too pessimistic and reflect improvements in fundamentals too slowly.” — Piotroski

“The profitability premium is about 1 percent higher per month among firms with smaller capitalization, higher return volatility, higher cash flow volatility, less analyst coverage, larger analyst forecast dispersion, fewer institutional holdings, higher idiosyncratic return volatility, lower dollar trading volume, higher bid-offer spread, lower credit rating, higher illiquidity, and that are younger.”

References

• novelinvestor summary