Investors are always warned not to put all their eggs in one basket. It’s less risky and more rewarding to spread money around.
Traditionally, this approach involved investing a certain percentage of money in bonds and another chunk in stocks of various types. This has gotten a lot easier with the explosion of passive investments such as exchange-traded funds, especially those tracking the stock-market indexes. All an investor has to do is pick an index to track, invest the money in the corresponding ETF and then sit back and watch.
But fund companies didn’t just stop there. In addition to funds tracking the indexes as they are, a whole industry of funds tracking the indexes in different ways also sprouted up.
All of this stock-index investing has been a boon in a strong bull market, even with the recent pullback. But inevitably, people are hunting for ways to outperform. Lately, the focus has been on selecting factors such as the market value of a company or the relatively low value of its shares and other anomalies that are thought to offer a little extra return.
Factor investing isn’t a new concept. Benjamin Graham focused on value decades ago on the belief that strong companies with undervalued shares would make for winning investments over time. In the 1960s, researchers looked at market value, and later they added attributes such as a stock’s momentum, volatility and yield to the list of factors to consider.
To put it simply, factors are another lens through which to evaluate potential investments. By size, small-cap stocks tend to outperform large-cap stocks even if they are riskier and more volatile, and that’s where the size factor comes in. The momentum factor expects stocks that are already rising to continue on that upward path as investor behaviour leads people to chase hot stocks. Stocks of companies that have strong competitive advantages tend to outperform others with lower volatility, the low-volatility factor.
So-called smart beta strategies take the indexes and recalibrate them according to one or more factors. Rather than peg to a market-cap-weighted index, for example, a smart beta fund might peg to an index that had been reweighted so all stocks are represented in the same proportion.
Factor investing straddles the space in between actively managed portfolios, where stocks are picked based on fundamental or technical features, and index-tracking passive investing, taking on some of the characteristics of both. On the passive side, it’s a systematic, low-cost way to invest. On the active side, it acts as another yardstick for performance.
It pays to remember that, as with active managers, no single factor is going to work all the time. Value investing has gone through a long bout of being out of favour, and the recent stock market has favoured large-cap technology stocks, even though the data point to small-cap stocks outperforming over the longer run. That’s why, like picking a diverse selection of stocks and bonds, it’s good to pick a diverse set of factors, such as value, momentum and low volatility, and combine them to smooth over those periods when one or more of them is lagging the market.
Researchers at AQR Capital Management, a global-investment management firm, further found that integrating the factors into the same stock portfolio makes more of a difference than managing them separately, and the more factors the better. Their research, based on models they built, found that the portfolio with integrated factors generated an additional 1-per-cent return. They concluded that it worked because screening for stocks that passed more than one factor added another layer of diversification.
James O’Shaughnessy, who wrote What Works on Wall Street in the 1990s, explains that he uses value, momentum and shareholder yield factors to find stocks that have the highest chance of outperforming.
For nearly 15 years on U.S. stocks, Validea has been tracking integrated factor models based on the investment criteria used by investing gurus such as Mr. O’Shaughnessy, Warren Buffett and Peter Lynch. In 2010, we started tracking our models on the Canadian equity market. In both markets, our Momentum model, which looks for companies with strong price momentum and earnings per share (EPS) growth that is coupled with high return on equity and falling debt, has shown impressive robustness in its results.
Using the Momentum model available on Validea Canada, which has returned 14.1 per cent since August, 2010, compared with 4.1 per cent for the TSX (price returns only), the table here lists the top scoring stocks.
John Reese is chief executive officer of Validea.com and Validea Capital, the manager of an actively managed ETF. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service.