Capturing Market Premiums

This is the second in a series of articles about evidence-based investing (EBI).  In the first article we introduced EBI and discussed some of the most important aspects of EBI.  

This article will focus on factor-based investing as a primary technique used in evidence-based investing to capture market premiums.   Factor-based investing has gained significant traction in the investment community as a disciplined approach that leverages academic research and empirical evidence to enhance portfolio performance. This strategy involves targeting specific investment factors that have historically exhibited persistent risk premia and returns above the market average. 

Risk premia, in the context of factor-based investing, refers to the additional returns investors expect to earn for taking on specific systematic risks associated with different factors. In other words, certain attributes or characteristics of securities carry additional risk, and investors demand compensation in the form of higher expected returns for bearing those risks. These risk premia are distinct from the return of the overall market, commonly represented by a market index like the S&P 500. 

Investors capture risk premia by targeting their portfolios toward specific factors that have historically rewarded investors with excess returns compared to the market average. The five most common equity factors in factor-based investing are:

1. Market Factor: This factor represents the excess return of the overall market, often measured by the market index such as the S&P 500.

2. Size Factor: The size factor captures the excess return of smaller companies over larger ones. Small-cap stocks historically have outperformed large-cap stocks over the long term.

3. Value Factor: The value factor focuses on the excess return of undervalued stocks relative to their fundamental metrics, such as low price-to-earnings ratios or price-to-book ratios.

4. Momentum Factor: Momentum identifies the excess return of stocks that have exhibited strong price performance in the recent past and is based on the belief that securities with strong trends tend to continue performing well.

5. Quality Factor: The quality factor seeks to capture the excess return of companies with strong financial health, stable earnings, and low debt levels.

Academic Research and Historical Evidence

The roots of factor-based investing can be traced back to the groundbreaking work of economists Eugene Fama and Kenneth French, who introduced the three-factor model in the early 1990s. Since then, this approach has evolved, and today, investors commonly consider a range of factors to design portfolios that aim to capture market premiums.

The discovery of factors that exhibit persistent risk premia and returns above the market average is primarily driven by empirical research and rigorous academic studies. Financial economists and researchers analyze vast amounts of historical data to identify patterns and correlations between the performance of different factors and their associated risk premia. Factors that have consistently demonstrated excess returns over long periods, across different market conditions and geographies, are deemed to exhibit persistence.

For example, researchers like Eugene Fama and Kenneth French have extensively studied the factors of Size and Value, and their empirical research has shown that smaller companies tend to outperform larger ones (Size Factor), and companies with low price-to-book ratios tend to outperform those with high ratios (Value Factor) over extended periods of time.

By understanding the historical evidence of persistent risk premia associated with specific factors, evidence-based investors can construct portfolios that tilt towards these factors. This strategy involves over-weighting securities that exhibit the desired factor characteristics and under-weighting those that do not. By doing so, investors aim to capture the risk premia and potentially achieve higher returns compared to traditional market capitalization-weighted strategies.

Over the years, additional research has validated and expanded the factor-based investing approach, uncovering new factors and refining existing ones. For instance, research by AQR Capital Management has highlighted the importance of the momentum and quality factors in driving excess returns.

Factor-Based Investing and Portfolio Strategies

Factor tilts in portfolio construction are key elements of factor-based investing. Portfolio managers create factor tilts to overweight or underweight certain factors in their portfolios based on their convictions and risk preferences. By tilting a portfolio towards factors that are expected to perform well, managers seek to capture additional returns while managing risk exposure.

Another popular approach is Smart Beta and Factor-Based ETFs. Smart beta refers to ETFs that track indexes constructed using factor-based methodologies. These ETFs aim to deliver better risk-adjusted returns compared to traditional market-cap-weighted index funds by explicitly targeting specific factors.

Evaluating Factor Performance

Understanding the persistence of factors is essential in factor-based investing. Persistence refers to the consistency of factor premiums over time. Research has shown that some factors, such as value and momentum, have exhibited higher levels of persistence compared to others.

Investors should care about persistence because factors that demonstrate more stable performance are more likely to provide predictable returns over the long term. However, it's essential to note that even persistent factors may experience periods of underperformance as we have seen with the value premium.  However, patience is required to capture their long-term benefits.

Factor timing involves dynamically adjusting factor exposures based on market conditions or economic indicators to capitalize on short-term fluctuations. While this strategy may seem appealing, it is challenging to implement successfully, as factor timing requires accurate predictions of future factor movements.

Factor timing and factor premiums are utilized in portfolio management through tactical asset allocation strategies. These strategies involve adjusting factor exposures based on the expected performance of specific factors, often driven by market signals or economic indicators. 

Pulling It All Together

Factor-based investing is a powerful strategy that allows investors to capture market premiums through a systematic and evidence-based approach. By targeting specific factors that have historically driven excess returns, factor-based investing seeks to optimize risk-adjusted performance over the long term.  

This strategy aligns well with the principles of evidence-based investing, where academic research and historical evidence form the basis for constructing well-diversified portfolios designed to meet investors' long-term financial goals.  

Ultimately, incorporating factor-based strategies into an evidence-based investing framework can lead to enhanced portfolio outcomes and a higher probability of achieving long-term financial success.